RISK CAPITAL REQUIREMENT & RAROC FRAMEWORK

FOR CORPORATE BANKING RELATIONSHIPS

CORPORATE RISK MANAGEMENT

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CONTENTS

1. 2. 3. 4.

INTRODUCTION............................................................................................................................... 3 ECONOMIC CAPITAL ..................................................................................................................... 4 RAROC ................................................................................................................................................ 5 INPUTS TO RISK MEASURE ......................................................................................................... 6 i. ii. iii. iv. v. vi. vii. Internal Risk Rating ...................................................................................................................... 6 Rating Migration and Probability of Default (PD)...................................................................... 7 Estimated Exposure at Default (EAD) ........................................................................................11 Estimated Loss Given Default (LGD) ..........................................................................................11 Spread ............................................................................................................................................12 Fees .................................................................................................................................................13 Operating Cost ..........................................................................................................................13

5. 6. 7.

EXPECTED LOSS (RISK PREMIUM) ..........................................................................................14 ECONOMIC CAPITAL MEASUREMENT ...................................................................................15 APPLICATION OF THE RAROC MODEL: .................................................................................16

ANNEXURE : COMPARISON OF RATING MIGRATIONS ...............................................................18 ANNEXURE : REGULATORY VERSUS IRB CAPITAL .....................................................................20 ANNEXURE : RAROC VERSUS RETURN ON REGULATORY CAPITAL .....................................21

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1.

INTRODUCTION

In a risk-return setting, borrowers placed in a high credit risk category should be priced higher than those in a low risk category. Thus, risk rating and therefore, expected probability of default is a key determinant of pricing. As in the case of pricing, risk rating has a bearing also on economic capital allocation in preference to merely regulatory capital allocation for the underlying asset. A standard risk adjusted measure of return is a tool for both pricing and making better lending decisions. The Risk-Adjusted Return on Capital (RAROC) framework, which is already put in place worldwide by large sized banks, is one such measure. The lender begins by charging an interest mark-up to cover the expected loss expected default rate of the rating category of the borrower. The lender then allocates enough capital to the prospective loan to cover the unexpected loss variability of default rates. The primary focus of RAROC is to provide an apples-toapples comparison of capital usage and return across business lines and risk types.

Bankers Trust in the 1970s first introduced the RAROC concept. Their original interest was to measure the risk of the banks portfolio, as well as the amount of equity capital necessary to limit the exposure of the banks depositors and other debt holders to a specified probability of loss. The recent surge among banks to adopt the RAROC approach is attributed to two forces: (i) the demand by shareholders for improved performance, especially the maximization of shareholder value and (ii) growth of conglomerates around profit centres. This has forced banks to develop a measurement of performance, especially when the capital of the bank is both costly and limited. RAROC is an integrated approach for measuring risk. It is a decision support tool, which enables the Bank to:

Calculate how much capital is needed to support all risks taken by the enterprise. Understand where the shareholders capital is invested. Compare risk-adjusted returns earned on that capital across dissimilar business lines and activities. Identify opportunities for risk transfer.

The purpose of this document is to lay down the framework and mechanism for computation of economic capital and Risk-adjusted pricing using internal ratings and internal default and loss data. The computation of economic capital in this manner will lead us further on the road to adoption of the Internal Ratings Based (IRB) approach for arriving at capital requirement for credit risk under the proposed New Basel Accord, when permitted by the regulator. The Risk-adjusted pricing approach will serve the dual purpose of ensuring that returns generated from a credit exposure is truly commensurate with the extent of risk assumed (capital at stake) and assessing the profit performance of individual business units relative to the assets booked by them, effectively a risk-based performance measurement tool.

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2.

ECONOMIC CAPITAL

Economic Capital is the amount of capital that an activity or business requires to support the economic risk it faces to a specified solvency standard or default probability. It protects the lender against unexpected volatility in the economic earnings of the firm. It is calculated from the aggregated risk distribution at the target solvency standard. Effectively, Economic Capital is a measure of the unexpected loss or economic capital at risk (VaR) as a result of the lending. Generally, international banks allocate enough capital so that the expected loan loss reserve or provision plus allocated capital covers over 99% of the loan loss outcomes.

Historically, two approaches have emerged to measure economic capital at risk. The first approach, following Bankers Trust, develops a market-based measure - maximum adverse change in the market value of a loan over the next year, as given in the block below:

Capital At Risk

McCauley Loan Duration x Loan Exposure x Expected Discounted Change in Credit Risk Premium

The second, following Bank of America among others, develops an experiential or historically based measure, as follows:

Economic Capital .

Exposure

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3.

RAROC

RAROC is the ratio of risk-adjusted income over a period, past or present, to the economic capital at risk for a business unit as a result of an activity (lending). Thus,

RAROC = Adjusted Income Economic Capital

Adjusted Income = Spread + Fees Expected Loss Operating Costs Spread It is the direct income earned on the loan, i.e. Loan Rate Banks Cost of Funds. Fees Non-interest income directly attributable to the loan over the relevant period (such as processing charges, commitment fees, LC / BG charges, fee from ancillary business, etc.). Expected Loss Probability of Default (PD) x Loss Given Default (LGD) x Exposure At Default (EAD) PD is the default probability over a given horizon for a particular rating class LGD is the estimated loss value of the loan or 1 minus recovery value of a loan on default. EAD is the estimated exposure at the time of default as a percentage of commitment Operating Costs It is the cost of executive time, effort, and resources in originating and monitoring a loan.

RAROC adjusts the profitability of each lending activity based on the cost of the capital that it requires. The RAROC calculated for a loan should be compared with the Banks expected Return on Equity (ROE). The ROE will be the Hurdle Rate. Where RAROC exceeds this Hurdle Rate, the loan will be considered as adding value to Banks capital and therefore, eligible for allocation of capital.

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4.

INPUTS TO RISK MEASURE

For computation of Risk Capital and RAROC, the following will be the fundamental inputs:

i. ii. iii. iv. v. vi. vii.

Internal Risk Rating Rating Migration and Probability of Default (PD) Estimated Exposure at Default (EAD) Estimated Loss Given Default (LGD) Spread Fees Operating Cost

We propose to compute Risk Capital and RAROC on a corporate relationship basis, using the following mechanism for arriving at each of the above inputs:

i.

Internal Risk Rating

The Bank has in March 2001, sourced, customized and adopted a corporate credit risk-rating model from CRISIL, christened by us as the i-Risk Rating System. The model delivers a quick assessment of a borrowers credit quality, structured analysis and grading of risk parameters and key parameters for tracking and controlling asset quality. The model in its basic form is designed to assess credit risk in a structured and comprehensive manner. i-Risk problem loan grades): Rating i-AAA i-AA+ i-AA i-A i-BBB i-BB+ i-BB i-B i-CC i-C Meaning Very Strong credit quality Strong credit quality Good credit quality Above average credit quality Average credit quality Moderate credit quality Weak credit quality Near Default credit Default credit Loss credit 5.50 4.75 4.25 3.75 3.25 2.75 2.25 1.75 1.50 1.00 Score Band 6.00 5.50 4.75 4.25 3.75 3.25 2.75 2.25 1.75 1.50 has 10 ratings, not including the modifiers, to match international best practices. The 10 ratings are as follows (the first 5 being pass grades and the last 5

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The above rating is based on an assessment of the borrower only without considering transaction characteristics and in that respect is uni-dimensional. By default, assets classified as Sub-Standard will be accorded a rating of i-CC and Doubtful assets accorded a rating of i-C. All exposures to the same corporate are assigned the same borrower rating, irrespective of any differences in the nature of each individual transaction. To introduce the second dimension transaction characteristics the Bank to begin with permits rating of the corporate guarantor to be superimposed on the borrower rating. Further, 100% cash collateralized exposures (for the individual transaction) are accorded a rating of i-AAA, while bank guaranteed exposures are accorded a rating equivalent to the rating of the bank. As and when sufficient reference data points are generated, the Bank will work towards adopting transaction characteristic Loss Given Default (LGD) estimates as the second dimension for the rating system. The transaction characteristics will be security, product type, tenor, etc.

The structure of the rating model, the parameters and risk factors assessed and the process to be followed for rating a corporate and reviewing the rating is documented separately (copy appended).

ii.

Rating Migration and Probability of Default (PD)

Using the internal risk-rating model, the bank will arrive at a credit rating for each exposure in its portfolio, every year. The model will be consistently used across the portfolio and over the years. The bank will capture ratings year-wise for each corporate in a database and track the upward and downward migration in rating for each exposure over the years. To compute the transition rate, each corporates rating at the end of a year (or the end of a horizon) is compared with its rating at the beginning of the year (or the beginning of the horizon). From these individual transitions, the bank will build a ten by ten transition matrix (frequency distribution) for a given horizon (e.g. 1 year, 2 years, etc.) on a portfolio level. illustration, the transition matrix for a given horizon will look as follows (transition year 1998-1999):
AAA AAA AA+ AA A BBB BB+ BB B CC C 1 1 6 1 7 AA+ 0 23 6 29 AA 10 69 13 1 93 A 16 66 10 92 38 BBB 17 18 2 BB+ 1 1 10 8 19 2 BB B 1 1 CC 1 2 0 3 2 C 1 1 Total 1 6 34 92 97 40 13 1 1 1 286

As an

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% AAA AA+ AA A BBB BB+ BB B CC C

AAA 100% 0% 0% 0% 0% 0% 0% 0% 0% 0%

AA+ 0% 100% 3% 0% 0% 0% 0% 0% 0% 0%

AA 0% 0% 68% 7% 0% 0% 0% 0% 0% 0%

A 0% 0% 29% 75% 13% 3% 0% 0% 0% 0%

BBB 0% 0% 0% 17% 68% 25% 0% 0% 0% 0%

BB+ 0% 0% 0% 1% 18% 45% 15% 0% 0% 0%

BB 0% 0% 0% 0% 1% 25% 62% 0% 0% 0%

B 0% 0% 0% 0% 0% 0% 8% 100% 0% 0%

CC 0% 0% 0% 0% 0% 3% 15% 0% 0% 0%

C 0% 0% 0% 0% 0% 0% 0% 0% 100% 100%

Total 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

As per the above matrix, of 34 exposures (100%), which were rated AA in Year 1998, 23 (68%) retained their rating in Year 1999 (1 year horizon) while 10 (29%) slipped to A rating and 1 (3%) moved up to AA+ rating. Similarly of 40 exposures (100%) rated BB+ in Year 1998, 18 (45%) remained at BB+ in Year 1999, whereas 10 (25%) upgraded to BBB and 1 (3%) to A while 10 (25%) slipped to BB and 1 (3%) defaulted (CC & C).

The bank will build transition matrixes as above for every year (where the horizon is one year). From these matrixes, a mean (probability) transition matrix and a standard deviation matrix will be generated. The mean transition matrix will throw up the probability of an exposure with a given rating migrating upward or downward, including to a default stage (called Probability of Default PD - in the latter case) over a given horizon. For example, assuming the above matrix to be a mean transition matrix, the Probability of Default (PD) of a corporate rated BB over a one-year period is 15% (slippage to CC and C), while for a AA rated corporate rate the PD is estimated as nil. A default will be considered to have occurred with regard to a particular borrower when one or more of the following events has taken place (in accordance with BIS guidelines):

i.

It is determined that the borrower is unlikely to pay its debt obligations (principal, interest, fees) in full.

ii.

A credit loss event associated with an obligation of the borrower, such as a charge-off, specific provision or distressed restructuring involving the forgiveness or postponement of principal, interest or fees

iii. iv.

The borrower is past due more than 90 days on any credit obligation The borrower has filed for bankruptcy or similar protection from creditors

Each internal risk rating will be associated with a particular long-run average PD over a stated horizon. This historical default / migration data will enable relating the rating to a relative frequency of default

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(default-mode paradigm) or they become the basis for the valuation of an asset (mark-to-model paradigm).

The Bank will, going forward, give the PD estimates a forward looking adjustment based on factors, which it considers, relevant based on empirical evidence and historical information. The adjustments will be applied through a well-developed and well-documented thought process and analysis. It will have to be ensured that the adjustments are applied conservatively and consistently over time.

After the first run of ratings for each corporate in the portfolio based on financials of FY 2000, we have built up a database for capturing the year-wise ratings transition of each corporate in the portfolio. In order to arrive at the probability of migration across ratings and in particular the probability of default of a corporate with a given rating, it is imperative that historical data on ratings transition exists. To achieve the above, a project was undertaken in September 2001 to back-rate for each of the previous years each of the corporate in the banks portfolio (this was done back till FY 1997). We, thus, captured ratings for FY 1997, FY 1998, FY 1999 and FY 2000. By then the ratings based on FY 2001 had also commenced. The ratings based on FY 2002 are now flowing in. From each years ratings (frequency distribution) of the corporates in the portfolio, we have built up the one-year (horizon) transition matrix (for 4 transitions FY 1997- FY 1998, FY 1998- FY 1999, FY 1999FY 2000, FY 2000- FY 2001; the transition matrix for FY 2001-FY 2002 is being populated as the FY 2002 ratings flow in). From the 4 one-year ratings transition matrix, the average matrix and the standard deviation matrix has been built up these will be periodically updated as further ratings of corporates, and for following years, get generated. The current actual average one-year transition matrix is as follows:
Average

% AAA AA+ AA A BBB BB+ BB B CC C

AAA 100.00%

AA+

AA

BBB

BB+

BB

CC

PD 0.00%

58.33% 7.90% 0.26%

30.21% 59.60% 14.05% 0.26%

11.46% 31.10% 66.33% 30.34% 4.68% 1.39% 18.29% 55.30% 26.16% 0.67% 11.44% 44.52% 14.37% 1.22% 18.29% 55.85% 14.42% 75.00% 0.40% 1.44% 6.34% 15.36% 25.00% 61.06% 38.94% 100.00%

0.00% 0.00% 0.40% 1.44% 6.34% 15.36% 25.00% 100.00% 100.00%

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The last column (PD) gives the Probability of Default over a one-year horizon for each rating. The PDs will dynamically be revised as further data flows into the transition matrix. A comparison of CRISILs and ICRAs average one-year transition rates versus our transition rates is given in the Annexure to this document. For the purpose of the RAROC framework, to begin with, the following PDs for each performing grade will be used (percentage converted into decimal terms, i.e. 0.50% stated as 0.0050 and an upward differential correction given to PDs of AA+ and AA ratings):

Rating AAA AA+ AA A BBB BB+ BB B

PD 0.0000 0.0005 0.0010 0.0040 0.0144 0.0634 0.1536 0.2500

In order that the ratings migration matrix and the probability of default is upto-date, it is extremely essential that branches are prompt in annually re-rating their exposures using the i-Risk Rating model immediately on receipt of the previous year end financials (without waiting for the periodical review / renewal of the account). Branches should obtain the financials as soon as these are ready with the company. Delays in populating the ratings afresh could result in the following:

The Bank may over-price a good credit and end up losing the business to competition A risky credit could get under-priced and the Banks earnings would not be commensurate with the risk assumed The risk measure of the individual exposure or portfolio could get under or over-stated due to which the Banks capital could get sub -optimally utilized.

For the Bank to benefit from the Internal Ratings Based approach for capital measurement, it is all the more necessary that the ratings are reviewed promptly every year and the ratings migration maintained real-time.

Rating initiators should be balanced in their assessment of the risk factors underlying a credit. Any attempt to play down a risk unreasonably pull down a rating will impact the stability of the rating system on one hand and on the other distort the migration statistics and the expected distribution and trend of the portfolio. To illustrate, assume that a i-BBB rated corporate is pushed up to a rating of i -A. In the unfortunate event that this borrower defaults during the year, this transition from A to default grade will resultantly

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increase the default probability of A rating category. In the process, all assets rated A might have to thereafter bear a higher price (risk premium) and capital requirement compared to existing, thanks to the mis-classification. Level 2 and Level 3 confirmers in the rating system are, therefore, expected to play the balancing role to ensure that inconsistencies do not occur.

iii.

Estimated Exposure at Default (EAD)

EAD is the estimated exposure at the time of default as a percentage of commitment. The bank will need to capture data on every exposure, which defaulted in the history of the bank (ideally) or minimum over one economic cycle. The types of data that the bank will capture for each exposure are:

a. b. c.

Nature and size of committed exposures on and off balance sheet at the time of default Actual exposure at the time of default Activity / industry

Principally, (a) and (b) above, for all defaulted credits, will be used for computing the estimated Exposure At Default (EAD) in percentage terms.

We have captured data on every exposure, which has defaulted (to NPA category) in the history of the bank. The data captured for each exposure are:

a. b. c. d. e.

Name of Account in default Nature of committed exposures on and off balance sheet at the time of default Quantum of committed exposures on and off balance sheet at the time of default Actual exposure at the time of default Activity / industry

From (c) and (d) above for all defaulted credits, the estimated Exposure At Default (EAD) was computed in percentage terms. As per data as on 31st March 2002, the EAD estimate works out to 76%. This estimated EAD will be periodically recomputed in the event of fresh defaults.

iv.

Estimated Loss Given Default (LGD)

LGD is the estimated loss value of the loan or 1 minus recovery value of a loan on default. For each of the defaulted exposures in (iii) above, the Bank will additionally capture the following information:

a.

Date of default

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b. c.

Amount and date of each recovery made in the credit after default Expenses incurred on the credit after default for legal proceedings, maintenance of security, recoveries, etc.

d.

Nature, seniority, share and value of security

The bank will discount the cash flows and work out the Present Value of the net recovery in the credit as at the time of default. The net recovery as a percentage of the actual exposure at the time of default will give the recovery rate (%). 100 minus the recovery rate (%) will yield the Loss Given Default (LGD), expressed in percentage terms. This will be computed for each exposure to arrive at an overall estimated LGD.

Besides an overall LGD, it would be also advisable that the bank captures LGD specific to each industry. This of course provided there is adequate representation of defaults in each industry. The objective of such fragmentation is that each industry depending on the stage of its economic cycle, contribution to GDP, phase of technology, etc., will have a different recovery potential out of the operations of the company or the assets of the defaulting corporate in such an industry. To illustrate, under current economic conditions, the prospects of recovery in a credit related to a dyes & pigments industry would be very low compared to recovery in a credit related to a FMCG industry. LGDs could also be captured by seniority of charge on security and by type of exposure.

For each of the defaulted exposures (NPAs), we have captured the following information:

a. b. c.

Date of default Amount and date of each recovery made in the credit after default Expenses incurred on the credit after default for legal proceedings, maintenance of security, recoveries, etc.

The LGD was computed for each exposure to arrive at an overall estimated LGD, which as on 31st March 2002 worked out to 88%. This estimated LGD would be periodically computed to factor in fresh recoveries, costs, defaults, if any.

v.

Spread

The difference between the stipulated interest rate on the credit and the cost of funding it is the spread. Cost of funding used for the RAROC framework will be the prevailing FTP for the particular exposure horizon.

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vi.

Fees

On a relationship basis, will include processing charges, non-interest income from non-fund based credit facilities, forex income, fee income from ancillary services, etc, as per rates stipulated.

vii.

Operating Cost

This will be computed on a look-back basis or budgets for the current year. The annual operating expenses as a percentage of aggregate of deposits, advances, investments and off-balance sheet exposure, will be multiplied by the total exposure to arrive at the overheads for the related account. For corporate banking relationships, the operating cost per Rs 100 of business (advances + contingent + deposits) has been computed at Rs 0.23 (i.e. 0.23%) using the following data: Budget as on 31st March 2003

Average Advances Average Contingent Average Deposits Operating Expenses

Rs 3538 crore Rs 1669 crore Rs 3750 crore Rs 20.79 crore

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5.

EXPECTED LOSS (Risk Premium)

The Expected Loss (EL) corresponding to each rating will be the product of the Probability of Default (PD) for that rating, the estimated Exposure at Default (EAD) and the estimated Loss Given Default (LGD). Based on the information for each of these variables given earlier in this paper, the rating-wise EL is as follows:

Rating AAA AA+ AA A BBB BB+ BB B

PD 0.0000 0.0005 0.0010 0.0040 0.0144 0.0634 0.1536 0.2500

Expected Loss (Risk Premium) 0.00% 0.03% 0.07% 0.27% 0.96% 4.24% 10.27% 16.72%

The Expected Loss should be recovered from pricing as a risk premium. Alternatively, suitable specific provisioning should cover this. The Bank could consider carving out the risk premium from each exposures pricing and building up the provision cover.

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6.

ECONOMIC CAPITAL MEASUREMENT

To arrive at the Economic Capital, the risk related capital requirement formula as proposed in the Basel Capital Accord II under Internal Ratings Based approach, will be used. However, as this factor includes Expected Loss component, the Expected Loss as worked out above separately for each rating will be deducted from the capital requirement computed using the IRB formula to give the Economic Capital for the RAROC framework. The formula in the Accord is as follows (the confidence level used in 99.90%)

Capital Requirement (K) = LGD x M x N[(1-R)^-0.5xG(PD)+(R/(1-R))^0.5xG(0.999)]

LGD = Loss Given Default M = Maturity Factor = 1+0.047x((1-PD)/PD^0.44) PD = Probability of Default N ( ) = Standard Normal Cumulative Distribution Function, with mean 0 and standard deviation 1. G ( ) = Inverse Standard Normal Cumulative Distribution Function, with mean 0 and standard deviation 1. R = Correlation = 0.10 x (1-EXP(-50xPD))/(1-EXP(-50))+0.20x[1-(1-EXP(-50xPD))/(1-EXP(50))] EXP ( ) = Natural Exponential Function

Using the above formula, the rating wise Capital Requirement and the Economic Capital after netting off Expected Loss is as follows:

Rating AAA AA+ AA A BBB BB+ BB B

Expected Loss 0.00% 0.03% 0.07% 0.27% 0.96% 4.24% 10.27% 16.72%

IRB Capital Req. 0.56% 2.52% 3.61% 7.15% 12.22% 22.12% 35.13% 44.52%

Economic Capital (IRB Cap Exp Loss) 1.40% @ 2.49% 3.54% 6.88% 11.26% 17.88% 24.86% 27.80%

@ Minimum requirement

A comparison of capital requirement as per the above capital measures versus current regulatory requirement of 9% for the corporate banking portfolio as on 31 st March 2002 is given in the Annexure.

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7.

APPLICATION OF THE RAROC MODEL:

Using the above inputs, RAROC will be computed as follows for each relationship: Spread + Fees Operating Costs Risk Premium (Expected Loss) -------------------------------------------------------------------------------Economic Capital

RAROC =

The targeted RAROC will be 25% (hurdle rate). To achieve this target, and considering the Economic Capital, Risk Premium, Operating Cost worked out above, Corporate Banking will need to leverage a minimum Spread plus Fees, rating-wise as follows, from the relationship:

Rating AAA AA+ AA A BBB BB+ BB B

Spread + Fees (as percentage of exposure) 0.58% 0.93% 1.23% 2.23% 3.98% 8.98% 16.73% 23.98%

(Exposure for the above purpose, will be: Fund Based : 100% of limit sanctioned, Non-fund Based : 50% of limit sanctioned till March 2003, 100% thereafter and Forex Limit : 100% of limit sanctioned)

To illustrate, as per the RAROC framework devised above, the rating-wise pricing structure will be as follows, considering 29th July 2002 FTPs, for fund based facilities:
FTP 6.58% 6.65% 6.75% 6.70% 6.78% 6.84% 7.57% 7.90% 8.66% 8.82%

RATING AAA AA+ AA A BBB BB+ BB B

7-14 days 7.16% 7.51% 7.81% 8.81% 10.56% 15.56% 23.31% 30.56%

15-30 7.23% 7.58% 7.88% 8.88% 10.63% 15.63% 23.38% 30.63%

31-45 7.34% 7.69% 7.99% 8.99% 10.74% 15.74% 23.49% 30.74%

46-90 7.28% 7.63% 7.93% 8.93% 10.68% 15.68% 23.43% 30.68%

91-180 7.36% 7.71% 8.01% 9.01% 10.76% 15.76% 23.51% 30.76%

181-270 7.42% 7.77% 8.07% 9.07% 10.82% 15.82% 23.57% 30.82%

271-365 8.15% 8.50% 8.80% 9.80% 11.55% 16.55% 24.30% 31.55%

1 yr 1 day2yrs 1 day- 3 1.5 1.5 yr 1 day-2 yrs 8.48% 8.83% 9.13% 10.13% 11.88% 16.88% 24.63% 31.88% 9.25% 9.60% 9.90% 10.90% 12.65% 17.65% 25.40% 32.65% 9.40% 9.75% 10.05% 11.05% 12.80% 17.80% 25.55% 32.80%

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Returns based on the above pricing on Current Regulatory Capital are given in the Annexure (RAROC versus Return on Regulatory Capital). Based on the comparison, it is suggested that till a Risk Based Capital framework (such as the Internal Ratings Based Approach) is accepted by the Regulator, pricing based on Scenario III in the annexure is accepted, i.e. pricing where both RAROC and Risk Adjusted Return on Regulatory Capital is 25% minimum.

Risk premiums are normally based on Default Probabilities over a 1-year horizon. Therefore, in the case of exposures with a tenor of over one year, the Bank needs to stipulate a pricing-reset clause linked to either the internal rating of the borrower or certain Events of Default (EODs), which have a direct bearing on the rating, so that at the end of each year the pricing can be revised to factor in the changed risk premium corresponding to the fresh rating of the corporate.

Credit proposals will henceforth use this model for fixing risk related pricing and determining account profitability both actual and projected, to understand the value of the relationship. Value of collateral, market forces, perceived value of accounts, future business potential, portfolio / industry exposure and strategic reasons may play an important role in pricing. However, any attempt at price-cutting for market share would result in mispricing of risk, adverse selection, and sub-optimal capital utilization.

Ideally, the RAROC model should be applied across the portfolio of the loan assets and aggregated. It should also be aggregated for the various business activities of the Bank, to arrive at the enterprise-wide risk-adjusted return on economic capital. To begin with the same shall be applied to individual corporate credit relationships. Branches can then work out the RAROC for the branch portfolio by extending the framework to the entire portfolio on an aggregate, to benchmark it against the targeted RAROC in the process it will ensure that higher earnings in another asset duly compensate any shortfall in earnings in an otherwise preferred low yield asset, so that targeted RAROC is achieved at branch level. The same principle should be followed at the Region Level and at the Country Level.

*******

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Annexure : COMPARISON OF RATING MIGRATIONS Our Banks Average One-Year Transition Rates (1997-2001)
% AAA AA+ AA A BBB BB+ BB B CC C PD 0.00% 58.33% 30.21% 11.46% 7.90% 0.26% 59.60% 31.10% 0.26% 1.39% 0.67% 1.22% 0.40% 1.44% 6.34% 75.00% 25.00% 61.06% 38.94% 14.05% 66.33% 18.29% 4.68% 0.00% 0.00% 0.40% 1.44% 6.34% 15.36% 25.00% 100.00% 100.00% 100.00%

AAA 100.00% AA+ AA A BBB BB+ BB B CC C

30.34% 55.30% 11.44%

26.16% 44.52% 18.29%

14.37% 55.85% 14.42% 15.36%

Crisil Average One-Year Transition Rates (1993 2000) Rating AAA AA A BBB BB B C & Below Data Points 154 500 759 317 117 16 32 ICRAs Average One-Year Transition Rates (1992 2001) Rating AAA AA A BBB NI NI Non-Investment (BB+ to D) Data Points 142 287 279 133 AAA 92.3% 1.7% AA 7.0% 86.4% 1.4% A 0.7% 10.1 83.5% 0.8% BBB 0.3% 7.5% 85.7% 2.6% NI 1.4% 7.5% 13.5% 58.1% AAA 96.8% 2.8% AA 3.2% 85.2% 3.3% 0.3% A 10.0% 82.3% 5.7% BBB 1.0% 8.8% 73.2% 2.6% BB 0.4% 3.2% 11.0% 58.1% B 0.4% 0.3% 1.9% 2.6% 62.5% C & Below 0.2% 2.1% 7.9% 36.7% 37.5% 100%

Remarks:

The long-run stability of our rating model is yet to be proved given its short history.

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CRISILs and ICRAs transition matrix cover almost a decade, which could be considered as one economic cycle. Our rating model is yet to go through a full economic cycle.

CRISILs and ICRAs reports on the transition acknowledge that deteriorating g eneral economic conditions have resulted in greater volatility / lesser stability in the ratings in the recent years this is reflected in our matrix which covers the recent years only.

Our ratings transition rates may not be truly comparable with that of CRISIL and ICRA due to possible differences in the underlying characteristics of the statistical population (number of data points, geographical spread of exposures, size of corporate entities, etc).

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Annexure : REGULATORY VERSUS IRB CAPITAL

Corporate Banking Exposure (Performing Assets) as on 31st March 2002

Rs in Crore

Rating i-AAA i-AA+ i-AA i-A i-BBB i-BB+ i-BB i-B Total

Risk Capital 1.40% 2.49% 3.54% 6.89% 11.25% 17.88% 24.86% 27.80%

FB O/S 11.38 112.95 530.12 1360.98 400.32 65.19 11.18 0.00 2492.12

NFB O/S 86.06 15.10 278.12 544.17 224.48 39.01 6.13 0.00 1193.44

Regulatory Capital (9%) 4.90 10.84 60.23 146.98 46.13 7.62 1.28 0.00 277.98

Risk Capital 0.76 3.00 23.70 112.48 57.68 15.14 3.54 0.00 216.31

Remarks Aggregate Risk Capital requirement is lower than Regulatory Capital requirement as on 31 st March 2002

Aggregate Risk Capital requirement relative to Regulatory Capital requirement will change with change in the composition of the portfolio.

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Annexure : RAROC VERSUS RETURN ON REGULATORY CAPITAL

Rs in Crore Risk Adjusted Return on Regulatory Capital 4% 7% 10% 19% 31% 50% 69%

Rating i-AAA i-AA+ i-AA i-A i-BBB i-BB+ i-BB i-B Total

Risk Capital 1.40% 2.49% 3.54% 6.89% 11.25% 17.88% 24.86% 27.80%

FB O/S 11.38 112.95 530.12 1360.98 400.32 65.19 11.18 0.00 2492.12

NFB O/S 86.06 15.10 278.12 544.17 224.48 39.01 6.13 0.00 1193.44

Regulatory Capital (9%) Risk Capital 4.90 10.84 60.23 146.98 46.13 7.62 1.28 0.00 277.98 0.76 3.00 23.70 112.48 57.68 15.14 3.54 0.00 216.31

Pricing Proposed 0.58% 0.93% 1.23% 2.23% 3.98% 8.98% 16.73% 23.98%

Return on Regulatory Capital 6% 10% 14% 25% 44% 100% 186%

RAROC 25% 27% 26% 25% 25% 25% 25%

28%

20%

25%

Portfolio Return on Regulatory Capital will change depending on the portfolio mix. Since the pricing is higher at the higher risk end, the Returns will expectedly increase as Risk increases. The Returns steeply increase in view of the risk premium required to be earned from the exposure, reflective of the propensity to default.

As the Risk Premium (Expected Loss) is netted from Returns, the Risk Adjusted Return on Regulatory Capital increases gradually as risk increases.

Related to targeted RAROC of 25%, the Risk Adjusted Return on Regulatory Capital obviously is much lower than the RAROC figure in the lower risk categories and then surpasses the RAROC figure as one moves up the risk band.

The pricing scenarios for RAROC target 25% (scenario I), Risk Adjusted Return on Regulatory Capital (Scenario II) target 25% and Minimum of Scenario I and Scenario II (Scenario III) are given below rating-wise. This is followed by the tenure-wise pricing structure for each Scenario. The Bank is required to maintain Capital as per current regulatory requirement till permission is acceded by the Regulator to move into a Risk-based Capital (Internal Ratings Based Approach, etc) framework. In order that the Bank generates the targeted minimum Return of 25% on Capital (satisfying both Current Regulatory Capital and Risk Capital), Scenario III pricing structure is recommended:

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Scenario I

Scenario II

Scenario III

Rating i-AAA i-AA+ i-AA i-A i-BBB i-BB+ i-BB i-B

Mark up for RAR on Mark up for RAR on Regulatory Capital AND Regulatory Cap 25% RAROC 25% Risk Premium Mark-up for RAROC 25% Note : (1) Pricing = Spread + Fees from the exposure (2) Overheads = 0.23% 0.00% 0.58% 2.75% 2.75% 0.03% 0.93% 2.77% 2.77% 0.07% 1.23% 2.80% 2.80% 0.27% 2.23% 3.00% 3.00% 0.96% 3.98% 3.70% 3.98% 4.24% 8.98% 7.00% 8.98% 10.27% 16.73% 13.05% 16.73% 16.72% 23.98% 19.50% 23.98%

Scenario I Effect - Overall pricing on Fund Based exposure Exposure Tenure FTP i-AAA i-AA+ i-AA i-A i-BBB i-BB+ i-BB i-B 7-14 days 6.58% 7.16% 7.51% 7.81% 8.81% 10.56% 15.56% 23.31% 30.56% 15-30 6.65% 7.23% 7.58% 7.88% 8.88% 10.63% 15.63% 23.38% 30.63% 31-45 6.75% 7.34% 7.69% 7.99% 8.99% 10.74% 15.74% 23.49% 30.74% 46-90 6.70% 7.28% 7.63% 7.93% 8.93% 10.68% 15.68% 23.43% 30.68% 91-180 6.78% 7.36% 7.71% 8.01% 9.01% 10.76% 15.76% 23.51% 30.76% 181-270 6.84% 7.42% 7.77% 8.07% 9.07% 10.82% 15.82% 23.57% 30.82% 271-365 7.57% 8.15% 8.50% 8.80% 9.80% 11.55% 16.55% 24.30% 31.55% 1 yr 1 day-1.5 1.5 yr 1 day-2 7.90% 8.66% 8.48% 9.25% 8.83% 9.60% 9.13% 9.90% 10.13% 10.90% 11.88% 12.65% 16.88% 17.65% 24.63% 25.40% 31.88% 32.65% 2yrs 1 day- 3 yrs 8.82% 9.40% 9.75% 10.05% 11.05% 12.80% 17.80% 25.55% 32.80%

Scenario II Effect - Overall pricing on Fund Based exposure Exposure Tenure FTP i-AAA i-AA+ i-AA i-A i-BBB i-BB+ i-BB i-B 7-14 days 6.58% 9.33% 9.35% 9.38% 9.58% 10.28% 13.58% 19.63% 26.08% 15-30 6.65% 9.40% 9.42% 9.45% 9.65% 10.35% 13.65% 19.70% 26.15% 31-45 6.75% 9.50% 9.52% 9.55% 9.75% 10.45% 13.75% 19.80% 26.25% 46-90 6.70% 9.45% 9.47% 9.50% 9.70% 10.40% 13.70% 19.75% 26.20% 91-180 6.78% 9.53% 9.55% 9.58% 9.78% 10.48% 13.78% 19.83% 26.28% 181-270 6.84% 9.59% 9.61% 9.64% 9.84% 10.54% 13.84% 19.89% 26.34% 271-365 7.57% 10.32% 10.34% 10.37% 10.57% 11.27% 14.57% 20.62% 27.07% 1 yr 1 day-1.5 1.5 yr 1 day-2 7.90% 8.66% 10.65% 11.41% 10.67% 11.43% 10.70% 11.46% 10.90% 11.66% 11.60% 12.36% 14.90% 15.66% 20.95% 21.71% 27.40% 28.16% 2yrs 1 day- 3 yrs 8.82% 11.57% 11.59% 11.62% 11.82% 12.52% 15.82% 21.87% 28.32%

Scenario III Effect - Overall pricing on Fund Based exposure Exposure Tenure FTP i-AAA i-AA+ i-AA i-A i-BBB i-BB+ i-BB i-B 7-14 days 6.58% 9.33% 9.35% 9.38% 9.58% 10.56% 15.56% 23.31% 30.56% 15-30 6.65% 9.40% 9.42% 9.45% 9.65% 10.63% 15.63% 23.38% 30.63% 31-45 6.75% 9.50% 9.52% 9.55% 9.75% 10.74% 15.74% 23.49% 30.74% 46-90 6.70% 9.45% 9.47% 9.50% 9.70% 10.68% 15.68% 23.43% 30.68% 91-180 6.78% 9.53% 9.55% 9.58% 9.78% 10.76% 15.76% 23.51% 30.76% 181-270 6.84% 9.59% 9.61% 9.64% 9.84% 10.82% 15.82% 23.57% 30.82% 271-365 7.57% 10.32% 10.34% 10.37% 10.57% 11.55% 16.55% 24.30% 31.55% 1 yr 1 day-1.5 1.5 yr 1 day-2 7.90% 8.66% 10.65% 11.41% 10.67% 11.43% 10.70% 11.46% 10.90% 11.66% 11.88% 12.65% 16.88% 17.65% 24.63% 25.40% 31.88% 32.65% 2yrs 1 day- 3 yrs 8.82% 11.57% 11.59% 11.62% 11.82% 12.80% 17.80% 25.55% 32.80%

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