Banks should adopt elaborate techniques to measure credit risk which may include both qualitative and quantitative techniques. Banks should also establish and utilize an internal credit risk rating framework in managing credit risk. The internal credit risk rating is a summary indicator of a bank’s individual credit exposures and categorizes all credits into various classes on the basis of underlying credit quality. This rating framework may incorporate, inter alia, the business risk (including industry characteristics, competitive position e.g. marketing/technological edge, management capabilities, etc.) and financial risk (including financial condition, profitability, capital structure, present and future cash flows, etc.). The rating system should be consistent with the nature, size and complexity of a bank’s activities.
|
An internal rating framework would facilitate banks in a number of ways such as:
|
| | | a. | Credit selection;
|
| | | b. | Amount of exposure;
|
| | | c. | Tenure and price of facility;
|
| | | d. | Frequency or intensity of monitoring;
|
| | | e. | Analysis of migration of deteriorating credits and more accurate computation of future loan loss provisions;
|
| | | f. | Deciding the level of approving authority of credit approval.
|
It is not the intention of these guidelines to prescribe any particular rating system. Banks can choose a rating system which commensurate with the size, nature and complexity of their business as well their risk profile. However, banks are encouraged to take into account the following factors in designing and implementing an internal rating system;
|
| | | a. | The rating system should explicitly define each risk rating grade. The number of grades on rating scale should be neither too large nor too small. A large number of grades may increase the cost of obtaining and analyzing additional information and thus make the implementation of rating system expensive. On the other hand, if the number of rating grades is too small it may not permit accurate characterization of the underlying risk profile of a loan portfolio;
|
| | | b. | The rating system should lay down an elaborate criteria for assigning a particular rating grade, as well as the circumstances under which deviations from criteria can take place;
|
| | | c. | The operating flow of the rating process should be designed in a way that promotes the accuracy and consistency of the rating system while not unduly restricting the exercise of judgment;
|
| | | d. | The operating design of a rating system should address all relevant issues including which exposures to rate; the division of responsibility for grading; the nature of ratings review; the formality of the process and specificity of formal rating definitions;
|
| | | e. | The rating system should ideally aim at assigning a risk rating to all credit exposures of the bank. However, the banks may decide as to which exposures needs to be rated taking into account the cost benefit analysis. The decision to rate a particular credit exposure could be based on factors such as exposure amount, nature of exposure(i.e. corporate, commercial, retail, etc.) or both. Generally corporate and commercial exposures are subject to internal ratings whereas consumer / retail loans are subject to scoring models;
|
| | | f. | Banks should take adequate measures to test and develop a risk rating system prior to adopting one. Adequate validation testing should be conducted during the design phase as well as over the life of the system to ascertain the applicability of the system to the bank’s portfolio. Furthermore, adequate training should be imparted to the staff to ensure uniformity in assignment of ratings;
|
| | | g. | Banks should clearly spell out the roles and responsibilities of different parties for assigning risk rating. Ratings are generally assigned /reaffirmed at the time of origination of a loan or its renewal /enhancement. Generally loan origination function initiates a loan proposal and also allocates a specific rating. This proposal passes through the credit approval process and the rating is also approved or recalibrated simultaneously by approving authority. This may, however, vary from bank to bank;
|
| | | h. | The rating process should take into account all relevant risk factors including borrower’s financial condition, size, industry and position in the industry; the reliability of financial statements of the borrower; quality of management; elements of transaction structure such as covenants, etc. before assigning a risk rating. The risk rating should reflect the overall risk profile of an exposure;
|
| | | i. | Banks should also ensure that risk ratings are updated periodically and are also reviewed as and when any adverse events occur. There should also be a periodic independent review of the risk ratings by a separate function independent of loan origination to ensure consistency and accuracy of ratings.
|
