RBI/2008-09/68
DBOD.No.BP.BC. 11 /21.06.001/2008-09

July 1, 2008

All Commercial Banks
(excluding Local Area Banks and Regional Rural Banks)

Dear Sir,

Master Circular - Prudential Guidelines on Capital Adequacy and Market Discipline - Implementation of the New Capital Adequacy Framework (NCAF)

Please refer to the circulars DBOD.No.BP.BC.90/20.06.001/2006-07 dated April 27, 2007 and DBOD.No.BP.BC.66/21.06.001/2007-08 dated March 26, 2008, in terms of which the ‘Guidelines on the implementation of NCAF' and ‘Guidelines for Pillar 2 - Supervisory Review Process under the NCAF', respectively, were issued. In order to enable the banks to have access to all the existing instructions on the subject, in a single document, a Master Circular has been prepared, and is furnished in the Appendix. It incorporates the Pillar 2 guidelines and the amendments / clarifications issued on the subject till June 30, 2008. A glossary of some of the terms used in this circular has been provided in Annex - 15. This Circular has also been placed on the website of the Bank (www.rbi.org.in).

2. We advise that this Master Circular consolidates the modifications / clarifications issued vide circulars /mailbox clarifications listed in Annex - 16.

Yours faithfully,

(Prashant Saran)
Chief General Manager-in-Charge

Implementation of New Capital Adequacy Framework

Part A : Guidelines on Minimum Capital Requirement

1. Introduction

1.1 With a view to adopting the Basle Committee on Banking Supervision (BCBS) framework on capital adequacy which takes into account the elements of credit risk in various types of assets in the balance sheet as well as off-balance sheet business and also to strengthen the capital base of banks, Reserve Bank of India decided in April 1992 to introduce a risk asset ratio system for banks (including foreign banks) in India as a capital adequacy measure. Essentially, under the above system the balance sheet assets, non-funded items and other off-balance sheet exposures are assigned prescribed risk weights and banks have to maintain unimpaired minimum capital funds equivalent to the prescribed ratio on the aggregate of the risk weighted assets and other exposures on an ongoing basis. Reserve Bank has issued guidelines to banks in June 2004 on maintenance of capital charge for market risks on the lines of ‘Amendment to the Capital Accord to incorporate market risks’ issued by the BCBS in 1996.

1.2 The BCBS released the "International Convergence of Capital Measurement and Capital Standards: A Revised Framework" on June 26, 2004. The Revised Framework was updated in November 2005 to include trading activities and the treatment of double default effects and a comprehensive version of the framework was issued in June 2006 incorporating the constituents of capital and the 1996 amendment to the Capital Accord to incorporate Market Risk. The Revised Framework seeks to arrive at significantly more risk-sensitive approaches to capital requirements. The Revised Framework provides a range of options for determining the capital requirements for credit risk and operational risk to allow banks and supervisors to select approaches that are most appropriate for their operations and financial markets.

2.Approach to implementation, Effective date and Parallel run

2.1 The Revised Framework consists of three-mutually reinforcing Pillars, viz. minimum capital requirements, supervisory review of capital adequacy, and market discipline. Under Pillar 1, the Framework offers three distinct options for computing capital requirement for credit risk and three other options for computing capital requirement for operational risk. These options for credit and operational risks are based on increasing risk sensitivity and allow banks to select an approach that is most appropriate to the stage of development of bank's operations. The options available for computing capital for credit risk are Standardised Approach, Foundation Internal Rating Based Approach and Advanced Internal Rating Based Approach. The options available for computing capital for operational risk are Basic Indicator Approach, Standardised Approach and Advanced Measurement Approach.

2.2 Keeping in view Reserve Bank’s goal to have consistency and harmony with international standards, it has been decided that all commercial banks in India (excluding Local Area Banks and Regional Rural Banks) shall adopt Standardised Approach (SA) for credit risk and Basic Indicator Approach (BIA) for operational risk. Banks shall continue to apply the Standardised Duration Approach (SDA) for computing capital requirement for market risks.

2.3 Effective Date: Foreign banks operating in India and Indian banks having operational presence outside India should migrate to the above selected approaches under the Revised Framework with effect from March 31, 2008. All other commercial banks (except Local Area Banks and Regional Rural Banks) are encouraged to migrate to these approaches under the Revised Framework in alignment with them but in any case not later than March 31, 2009.

2.4 Parallel Run: With a view to ensuring smooth transition to the Revised Framework and with a view to providing opportunity to banks to streamline their systems and strategies, banks were advised to have a parallel run of the revised Framework. The Boards of the banks should review the results of the parallel run on a quarterly basis. The broad elements which need to be covered during the parallel run are as under:

i) Banks should apply the prudential guidelines on capital adequacy – both current guidelines and these guidelines on the Revised Framework – on an on-going basis and compute their Capital to Risk Weighted Assets Ratio (CRAR) under both the guidelines.
ii) An analysis of the bank's CRAR under both the guidelines should be reported to the board at quarterly intervals.
iii) A copy of the quarterly reports to the Board should be submitted to the Reserve Bank, one each to Department of Banking Supervision, Central Office and Department of Banking Operations and Development, Central Office. While reporting the above analysis to the board, banks should also furnish a comprehensive assessment of their compliance with the other requirements relevant under the Revised Framework, which will include the following, at the minimum:

a) Board approved policy on utilization of the credit risk mitigation techniques, and collateral management;

b) Board approved policy on disclosures;

c) Board approved policy on Internal Capital Adequacy Assessment Process (ICAAP) along with the capital requirement as per ICAAP;

d) Adequacy of bank's MIS to meet the requirements under the New Capital Adequacy Framework, the initiatives taken for bridging gaps, if any, and the progress made in this regard;

e) Impact of the various elements / portfolios on the bank's CRAR under the revised framework;

f) Mechanism in place for validating the CRAR position computed as per the New Capital Adequacy Framework and the assessments / findings/ recommendations of these validation exercises;

g) Action taken with respect to any advice / guidance / direction given by the Board in the past on the above aspects.

2.5 Migration to other approaches under the Revised Framework: Banks are required to obtain the prior approval of the Reserve Bank to migrate to the Internal Rating Based Approach (IRBA) for credit risk and the Standardised Approach (TSA) or the Advanced Measurement Approach (AMA) for operational risk. Banks that propose to migrate to these approaches are encouraged to undertake an objective and strict assessment of their compliance with the minimum requirements for entry and on-going use of those approaches as prescribed in the International Convergence of Capital Measurement and Capital Standards (comprehensive version of the Revised Framework published by the Basel Committee on Banking Supervision in June 2006 – available on the Bank for International Settlements website www.bis.org). These banks may also assess their compliance with the various processes relevant to these approaches. The above assessments would help these banks in preparing a realistic roadmap indicating the specific milestones, timeline, and plans for achieving smooth and meaningful migration to the advanced approaches. A separate communication in this regard will be issued to banks at a later date, specifying the pre-requisites and procedure for approaching the Reserve Bank for seeking its prior approval for such migration. Notwithstanding the above, all banks should migrate to Standardised Approach for credit risk and Basic Indicator Approach for operational risk on the effective date.

3. Scope of Application

The revised capital adequacy norms shall be applicable uniformly to all Commercial Banks (except Local Area Banks and Regional Rural Banks), both at the solo level (global position) as well as at the consolidated level. A Consolidated bank is defined as a group of entities where a licensed bank is the controlling entity. A consolidated bank will include all group entities under its control, except the exempted entities. In terms of guidelines on preparation of consolidated prudential reports issued vide circular DBOD. No.BP.BC.72/ 21.04.018/ 2001-02 dated February 25, 2003, a consolidated bank may exclude group companies which are engaged in insurance business and businesses not pertaining to financial services. A consolidated bank should maintain a minimum Capital to Risk-weighted Assets Ratio (CRAR) as applicable to a bank on an ongoing basis.

4. Capital funds

4.1 General

4.1.1 Banks are required to maintain a minimum Capital to Risk-weighted Assets Ratio (CRAR) of 9 percent on an ongoing basis. The Reserve Bank will take into account the relevant risk factors and the internal capital adequacy assessments of each bank to ensure that the capital held by a bank is commensurate with the bank’s overall risk profile. This would include, among others, the effectiveness of the bank’s risk management systems in identifying, assessing / measuring, monitoring and managing various risks including interest rate risk in the banking book, liquidity risk, concentration risk and residual risk. Accordingly, the Reserve Bank will consider prescribing a higher level of minimum capital ratio for each bank under the Pillar 2 framework on the basis of their respective risk profiles and their risk management systems. Further, in terms of the Pillar 2 requirements of the New Capital Adequacy Framework, banks are expected to operate at a level well above the minimum requirement.

4.1.2 The minimum capital maintained by banks on implementation of the Revised Framework shall be subjected to a prudential floor, which shall be the higher of the following amounts:

a) Minimum capital required to be maintained as per the Revised Framework;
b) A specified per cent of the minimum capital required to be maintained as per the Basel I framework for credit and market risks. The specified per cent will progressively decline as indicated in Table 1.

Table 1 – Prudential floor

The adequacy and the need for the capital floors will be reviewed periodically on the basis of the quality and integrity of Basel II implementation in banks. In case the supervisory assessments indicate satisfactory level and quality of compliance by banks, the capital floor may be dispensed with even before the above period.

4.1.3 Banks are encouraged to maintain, at both solo and consolidated level, a Tier 1 CRAR of at least 6 per cent. Banks which are below this level must achieve this ratio on or before March 31, 2010.

4.1.4 A bank should compute its Tier 1 CRAR and Total CRAR in the following manner:

* RWA = Risk weighted Assets

4.1.5 Capital funds are broadly classified as Tier 1 and Tier 2 capital. Elements of Tier 2 capital will be reckoned as capital funds up to a maximum of 100 per cent of Tier 1 capital, after making the deductions/ adjustments referred to in paragraph 4.4.

4.2 Elements of Tier 1 capital

4.2.1 For Indian banks, Tier 1 capital would include the following elements:
i) Paid-up equity capital, statutory reserves, and other disclosed free reserves, if any;

ii) Capital reserves representing surplus arising out of sale proceeds of assets;

iii) Innovative perpetual debt instruments eligible for inclusion in Tier 1 capital, which comply with the regulatory requirements as specified in Annex 1;

iv) Perpetual Non-Cumulative Preference Shares (PNCPS), which comply with the regulatory requirements as specified in Annex – 2; and

v) Any other type of instrument generally notified by the Reserve Bank from time to time for inclusion in Tier 1 capital.

4.2.2 Foreign currency translation reserve arising consequent upon application of Accounting Standard 11 (revised 2003): ‘The effects of changes in foreign exchange rates’; shall not be an eligible item of capital funds.
4.2.3 For foreign banks in India, Tier 1 capital would include the following elements:
(i) Interest-free funds from Head Office kept in a separate account in Indian books specifically for the purpose of meeting the capital adequacy norms.

(ii) Statutory reserves kept in Indian books.

(iii) Remittable surplus retained in Indian books which is not repatriable so long as the bank functions in India.

(iv) Capital reserve representing surplus arising out of sale of assets in India held in a separate account and which is not eligible for repatriation so long as the bank functions in India.

(v)Interest-free funds remitted from abroad for the purpose of acquisition of property and held in a separate account in Indian books.

(vi) Head Office borrowings in foreign currency by foreign banks operating in India for inclusion in Tier 1 capital which comply with the regulatory requirements as specified in Annex 1 and

(viii) Any other item specifically allowed by the Reserve Bank from time to time for inclusion in Tier 1 capital.

4.2.4 Notes:

(i) Foreign banks are required to furnish to Reserve Bank, an undertaking to the effect that the bank will not remit abroad the 'capital reserve' and ‘remittable surplus retained in India’ as long as they function in India to be eligible for including this item under Tier 1 capital.

(ii) These funds may be retained in a separate account titled as 'Amount Retained in India for Meeting Capital to Risk-weighted Asset Ratio (CRAR) Requirements' under 'Capital Funds'.

(iii) An auditor's certificate to the effect that these funds represent surplus remittable to Head Office once tax assessments are completed or tax appeals are decided and do not include funds in the nature of provisions towards tax or for any other contingency may also be furnished to Reserve Bank.

(iv) The net credit balance, if any, in the inter-office account with Head Office / overseas branches will not be reckoned as capital funds. However, any debit balance in the Head Office account will have to be set-off against capital.

4.2.5 Limits on eligible Tier 1 capital

(i) The Innovative perpetual debt instruments(IPDIs), eligible to be reckoned as Tier 1 capital, will be limited to 15 percent of total Tier 1 capital as on March 31 of the previous financial year. The above limit will be based on the amount of Tier 1 capital as on March 31 of the previous financial year, after deduction of goodwill, DTA and other intangible assets but before the deduction of investments, as required in paragraph 4.4.

(ii) The outstanding amount of Tier 1 preference shares i.e Perpetual Non-Cumulative Preference Shares along with Innovative Tier 1 instruments shall not exceed 40 per cent of total Tier 1 capital at any point of time. The above limit will be based on the amount of Tier 1 capital after deduction of goodwill and other intangible assets but before the deduction of investments as per para 4.4.6 below. Tier 1 preference shares issued in excess of the overall ceiling of 40 per cent, shall be eligible for inclusion under Upper Tier 2 capital, subject to limits prescribed for Tier 2 capital. However, investors' rights and obligations would remain unchanged.

(iii) Innovative instruments / PNCPS, in excess of the limit shall be eligible for inclusion under Tier 2, subject to limits prescribed for Tier 2 capital.

4.3 Elements of Tier 2 capital

4.3.1 Revaluation reserves
These reserves often serve as a cushion against unexpected losses, but they are less permanent in nature and cannot be considered as ‘Core Capital’. Revaluation reserves arise from revaluation of assets that are undervalued on the bank’s books, typically bank premises. The extent to which the revaluation reserves can be relied upon as a cushion for unexpected losses depends mainly upon the level of certainty that can be placed on estimates of the market values of the relevant assets, the subsequent deterioration in values under difficult market conditions or in a forced sale, potential for actual liquidation at those values, tax consequences of revaluation, etc. Therefore, it would be prudent to consider revaluation reserves at a discount of 55 percent while determining their value for inclusion in Tier 2 capital. Such reserves will have to be reflected on the face of the Balance Sheet as revaluation reserves.

4.3.2 General provisions and loss reserves
Such reserves, if they are not attributable to the actual diminution in value or identifiable potential loss in any specific asset and are available to meet unexpected losses, can be included in Tier 2 capital. Adequate care must be taken to see that sufficient provisions have been made to meet all known losses and foreseeable potential losses before considering general provisions and loss reserves to be part of Tier 2 capital. Banks are allowed to include the ‘General Provisions on Standard Assets', Floating Provisions ‘Provisions held for Country Exposures’, and ‘Investment Reserve Account’ in Tier 2 capital. However, these four items will be admitted as Tier 2 capital up to a maximum of 1.25 per cent of the total risk-weighted assets.

4.3.3 Hybrid debt capital instruments
In this category, fall a number of debt capital instruments, which combine certain characteristics of equity and certain characteristics of debt. Each has a particular feature, which can be considered to affect its quality as capital. Where these instruments have close similarities to equity, in particular when they are able to support losses on an ongoing basis without triggering liquidation, they may be included in Tier 2 capital. Banks in India are allowed to recognise funds raised through debt capital instrument which has a combination of characteristics of both equity and debt, as Upper Tier 2 capital provided the instrument complies with the regulatory requirements specified in Annex 3. Indian Banks are also allowed to issue Perpetual Cumulative Preference Shares (PCPS), Redeemable Non-Cumulative Preference Shares (RNCPS) and Redeemable Cumulative Preference Shares (RCPS), as Upper Tier 2 Capital, subject to extant legal provisions as per guidelines contained in Annex 4.

4.3.4 Subordinated debt
To be eligible for inclusion in Tier 2 capital, the instrument should be fully paid-up, unsecured, subordinated to the claims of other creditors, free of restrictive clauses, and should not be redeemable at the initiative of the holder or without the consent of the Reserve Bank of India. They often carry a fixed maturity, and as they approach maturity, they should be subjected to progressive discount, for inclusion in Tier 2 capital. Instruments with an initial maturity of less than 5 years or with a remaining maturity of one year should not be included as part of Tier 2 capital. Subordinated debt instruments eligible to be reckoned as Tier 2 capital shall comply with the regulatory requirements specified in Annex 5.

The need for continuing with the prudential floor will be reviewed periodically by the Reserve Bank.

Total Tier 1 capital funds, subject to prudential limits for Innovative Perpetual Debt Instruments minus deductions from Tier 1 capital

Total of eligible Tier 1 capital funds and eligible Tier 2 capital funds, subject to prudential limits for Innovative Tier 1 instruments, Upper Tier 2 instruments and subordinated debt instruments minus deductions from Tier 1 and Tier 2 capital

Floating Provisions held by banks, which is general in nature and not made against any identified assets may be treated as part of Tier 2, if such provisions are not netted off from GNPAs to arrive at disclosure of net NPAs.

4.3.5 Innovative Perpetual Debt Instruments (IPDI) and Perpetual Non-Cumulative Preference Shares (PNCPS)

IPDI in excess of 15 per cent of Tier 1 capital {cf. Annexure I, Para 1(ii)} may be included in Tier 2, and PNCPS in excess of the overall ceiling of 40 per cent ceiling prescribed vide paragraph 4.2.5 {cf. Annexure 2. Para 1.1} may be included under Upper Tier 2 capital, subject to the limits prescribed for Tier 2 capital.

4.3.6 Any other type of instrument generally notified by the Reserve Bank from time to time for inclusion in Tier 2 capital.

4.3.7 Limits on Tier 2 Capital
Upper Tier 2 instruments along with other components of Tier 2 capital shall not exceed 100 per cent of Tier 1 capital. The above limit will be based on the amount of Tier 1 after deduction of goodwill, DTA and other intangible assets but before deduction of investments.

4.3.8 Subordinated debt instruments eligible for inclusion in Lower Tier 2 capital will be limited to 50 percent of Tier 1 capital after all deductions.

4.4 Deductions from capital

4.4.1 Intangible assets and losses in the current period and those brought forward from previous periods should be deducted from Tier 1 capital.

The DTA computed as under should be deducted from Tier 1 capital:

.i) DTA associated with accumulated losses; and
.ii) The DTA (excluding DTA associated with accumulated losses), net of DTL. Where the DTL is in excess of the DTA (excluding DTA associated with accumulated losses), the excess shall neither be adjusted against item (i) nor added to Tier 1 capital.

4.4.3 Any gain-on-sale arising at the time of securitisation of standard assets, as defined in paragraph 5.16.1, if recognised, should be deducted entirely from Tier 1 capital. In terms of guidelines on securitisation of standard assets, banks are allowed to amortise the profit over the period of the securities issued by the SPV. The amount of profits thus recognised in the profit and loss account through the amortisation process need not be deducted.

4.4.4 Banks should not recognise minority interests that arise from consolidation of less than wholly owned banks, securities or other financial entities in consolidated capital to the extent specified below:

i) The extent of minority interest in the capital of a less than wholly owned subsidiary which is in excess of the regulatory minimum for that entity.

ii) In case the concerned subsidiary does not have a regulatory capital requirement, the deemed minimum capital requirement for that entity may be taken as 9 per cent of the risk weighted assets of that entity.

4.4.5 Securitisation exposures, as specified in paragraph 5.16.2, shall be deducted from regulatory capital and the deduction must be made 50 per cent from Tier 1 and 50 per cent from Tier 2, except where expressly provided otherwise. Deductions from capital may be calculated net of any specific provisions maintained against the relevant securitisation exposures.

4.4.6 In the case of investment in financial subsidiaries and associates, the treatment will be as under for the purpose of capital adequacy:

(i) The entire investments in the paid up equity of the financial entities (including insurance entities), which are not consolidated for capital purposes with the bank, where such investment exceeds 30% of the paid up equity of such financial entities and entire investments in other instruments eligible for regulatory capital status in those entities shall be deducted, at 50 per cent from Tier 1 and 50 per cent from Tier 2 capital. (For investments less than 30 per cent, please para 5.13.7)

(ii) Banks should ensure that majority owned financial entities that are not consolidated for capital purposes and for which the investment in equity and other instruments eligible for regulatory capital status is deducted, meet their respective regulatory capital requirements. In case of any shortfall in the regulatory capital requirements in the de-consolidated entity, the shortfall shall be fully deducted at 50 per cent from Tier 1 capital and 50 per cent from Tier 2 capital.

4.4.7 An indicative list of institutions which may be deemed to be financial institutions for capital adequacy purposes is as under:

• Banks,
• Mutual funds,
• Insurance companies,
• Non-banking financial companies,
• Housing finance companies,
• Merchant banking companies,
• Primary dealers.

4.4.8 A bank's aggregate investment in all types of instruments, eligible for capital status of investee banks / FIs / NBFCs / PDs as listed in paragraph 4.4.9 below, excluding those deducted in terms of paragraph 4.4.6, should not exceed 10 per cent of the investing bank's capital funds (Tier 1 plus Tier 2, after adjustments). Any investment in excess of this limit shall be deducted at 50 per cent from Tier 1 and 50 per cent from Tier 2 capital. Investments in equity or instruments eligible for capital status issued byFIs / NBFCs / Primary Dealers which are, within the aforesaid ceiling of 10 per cent and thus, are not deducted from capital funds, will attract a risk weight of 100 per cent or the risk weight as applicable to the ratings assigned to the relevant instruments, whichever is higher. As regards the treatment of investments in equity and other capital-eligible instruments of scheduled banks, within the aforesaid ceiling of 10 per cent, will be risk weighted as per paragraph 5.6.1. Further, in the case of non-scheduled banks, where CRAR has become negative, the investments in the capital-eligible instruments even within the aforesaid 10 per cent limit shall be fully deducted at 50 per cent from Tier 1 and 50 per cent from Tier 2 capital, as per paragraph 5.6.1.

4.4.9 Banks' investment in the following instruments will be included in the prudential limit of 10 per cent referred to at paragraph 4.4.8 above.
a) Equity shares;
b) Perpetual Non-Cumulative Preference Shares
c) Innovative Perpetual Debt Instruments
d) Upper Tier II Bonds
e) Upper Tier II Preference Shares (PCPS/RNCPS/RCPS)
f) Subordinated debt instruments;
g) Any other instrument approved by the RBI as in the nature of capital.

4.4.10 The investments made by a banking subsidiary/associate in the equity or non equity regulatory-capital instruments issued by its parent bank, should be deducted from such subsidiary's regulatory capital at 50 per cent each from Tier 1 and Tier 2 capital, in its capital adequacy assessment on a solo basis.The regulatory treatment of investment by the non-banking financial subsidiaries / associates in the parent bank's regulatory capital would, however, be governed by the applicable regulatory capital norms of the respective regulators of such subsidiaries / associates.

5.Capital Charge for Credit Risk

5.1 General

Under the Standardised Approach, the rating assigned by the eligible external credit rating agencies will largely support the measure of credit risk. The Reserve Bank has identified the external credit rating agencies that meet the eligibility criteria specified under the revised Framework. Banks may rely upon the ratings assigned by the external credit rating agencies chosen by the Reserve Bank for assigning risk weights for capital adequacy purposes as per the mapping furnished in these guidelines.

5.2 Claims on Domestic Sovereigns

5.2.1 Both fund based and non fund based claims on the central government will attract a zero risk weight. Central Government guaranteed claims will attract a zero risk weight.

5.2.2 The Direct loan / credit / overdraft exposure, if any, of banks to the State Governments and the investment in State Government securities will attract zero risk weight. State Government guaranteed claims will attract 20 per cent risk weight’

5.2.3 The risk weight applicable to claims on central government exposures will also apply to the claims on the Reserve Bank of India, DICGC and Credit Guarantee Fund Trust for Small Industries (CGTSI). The claims on ECGC will attract a risk weight of 20 per cent.

5.2.4 The above risk weights for both direct claims and guarantee claims will be applicable as long as they are classified as ‘standard’/ performing assets. Where these sovereign exposures are classified as non-performing, they would attract risk weights as applicable to NPAs, which are detailed in Paragraph .

5.3 Claims on Foreign Sovereigns

5.3.1 Claims on foreign sovereigns will attract risk weights as per the rating assigned to those sovereigns / sovereign claims by international rating agencies as follows:

Table 2: Claims on foreign sovereigns – Risk weights

* Standard & Poor’s

5.3.2 Claims denominated in domestic currency of the foreign sovereign met out of the resources in the same currency raised in the jurisdiction of that sovereign will, however, attract a risk weight of zero percent.

5.3.3 However, in case a Host Supervisor requires a more conservative treatment to such claims in the books of the foreign branches of the Indian banks, they should adopt the requirements prescribed by the Host Country supervisors for computing capital adequacy.

5.4 Claims on public sector entities (PSEs)

5.4.1 Claims on domestic public sector entities will be risk weighted in a manner similar to claims on Corporates.

5.4.2 Claims on foreign PSEs will be risk weighted as per the rating assigned by the international rating agencies as under:

Table 3: Claims on foreign PSEs – Risk weights

5.5 Claims on MDBs, BIS and IMF

Claims on the Bank for International Settlements (BIS), the International Monetary Fund (IMF) and the following eligible Multilateral Development Banks (MDBs) evaluated by the BCBS will be treated similar to claims on scheduled banks meeting the minimum capital adequacy requirements and assigned a uniform twenty percent risk weight :

a) World Bank Group: IBRD and IFC,
b) Asian Development Bank,
c) African Development Bank,
d) European Bank for Reconstruction & Development,
e) Inter-American Development Bank,
f) European Investment Bank,
g) European Investment Fund,
h) Nordic Investment Bank,
i) Caribbean Development Bank,
j) Islamic Development Bank and
k) Council of Europe Development Bank.

Similarly, claims on the International Finance Facility for Immunization (IFFIm) will also attract a twenty per cent risk weight.

5.6 Claims on banks
5.6.1 The claims on banks incorporated in India and the branches of foreign banks in India, other than those deducted in terms of paragraph 4.4.6., 4.4.8 and 4.4.10 above,, will be risk weighted as under:

Vide Sl No.1 of Annex to circular DBOD.BP.BC.No.67/21.06.001/2007-08 dated March 31, 2008

Vide Sl. No.2 in Annex to circular DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

Vide paragraph 2.2 of circular DBOD.No.BP.BC.88/21.06.001/2007-08 dated May 30, 2008

Vide Sl. No.3 in Annex to circular DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

For example: The risk weight assigned to an investment in US Treasury Bills by SBI branch in Paris, irrespective of the currency of funding, will be determined by the rating assigned to the Treasury Bills, as indicated in Table 2.

For example: The risk weight assigned to an investment in US Treasury Bills by SBI branch in New York will attract a zero per cent risk weight, irrespective of the rating of the claim, if the investment is funded from out of the USD denominated resources of SBI, New York. In case the SBI, New York, did not have any USD denominated resources, the risk weight will be determined by the rating assigned to the Treasury Bills, as indicated in Table 2 above.

Vide Sl. No.4 of the Annex to DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

Vide Appendix -1 to Annex to circular DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

Table 4: Claims on banks incorporated in India and foreign bank branches in India

* The deduction should be made @ 50% each, from Tier 1 and Tier 2 capital.
Notes:
i) In the case of banks where no capital adequacy norms have been prescribed by the RBI, the lending / investing bank may calculate the CRAR of the cooperative bank concerned, notionally, by obtaining necessary information from the investee bank, using the capital adequacy norms as applicable to the commercial banks. In case, it is not found feasible to compute CRAR on such notional basis, the risk weight of 350 or 625 per cent, as per the risk perception of the investing bank, should be applied uniformly to the investing bank’s entire exposure.

ii) In case of banks where capital adequacy norms are not applicable at present, the matter of investments in their capital-eligible instruments would not arise for now. However, column No. 2 and 4 of the Table above will become applicable to them, if in future they issue any capital instruments where other banks are eligible to invest.

5.6.2 The claims on foreign banks will be risk weighted as under as per the ratings assigned by international rating agencies.
Table 5: Claims on foreign banks – Risk weights

The exposures of the Indian branches of foreign banks, guaranteed / counter-guaranteed by the overseas Head Offices or the bank’s branch in another country would amount to a claim on the parent foreign bank and would also attract the risk weights as per Table 5 above.
5.6.3 However, the claims on a bank which are denominated in 'domestic' foreign currency met out of the resources in the same currency raised in that jurisdiction will be risk weighted at 20 per cent provided the bank complies with the minimum CRAR prescribed by the concerned bank regulator(s).
5.6.4 However, in case a Host Supervisor requires a more conservative treatment for such claims in the books of the foreign branches of the Indian banks, they should adopt the requirements prescribed by the Host supervisor for computing capital adequacy.

5.7Claims on Primary Dealers

Claims on Primary Dealers shall be risk weighted in a manner similar to claims on corporates.

5.8 Claims on corporates

5.8.1 Claims on corporates, including the exposures on Asset Finance companies, shall be risk weighted as per the ratings assigned by the rating agencies registered with the SEBI and chosen by the Reserve Bank of India. The following table indicates the risk weight applicable to claims on corporates. The standard risk weight for unrated claims on corporates up to the threshold level specified in paragraph 5.8.2 will be 100 per cent. No claim on an unrated corporate may be given a risk weight preferential to that assigned to its sovereign of incorporation.

Added in terms of the Mail Box clarification dated June 24, 2008.

For example: A Euro denominated claim of SBI branch in Paris on BNP Paribas, Paris which is funded from out of the Euro denominated deposits of SBI, Paris will attract a 20 per cent risk weight irrespective of the rating of the claim, provided BNP Paribas complies with the minimum CRAR stipulated by its regulator/supervisor in France. If BNP Paribas were breaching the minimum CRAR, the risk weight will be as indicated in Table 4 above.

Claims on corporates will include all fund based and non fund based exposures other than those which qualify for inclusion under ‘sovereign’, ‘bank’, ‘regulatory retail’, ‘residential mortgage’, ‘non performing assets’, specified category addressed separately in these guidelines.

Vide DBOD Mail Box clarification dated May 21, 2008

Table 6: Part A – Long term claims on corporate – Risk weights

Table 6 : Part B - Short Term Claims on Corporate - Risk Weights

5.8.2 The Reserve Bank may increase the standard risk weight for unrated claims where a higher risk weight is warranted by the overall default experience. As part of the supervisory review process, the Reserve Bank would also consider whether the credit quality of unrated corporate claims held by individual banks should warrant a standard risk weight higher than 100 per cent. To begin with, for the financial year 2008-09, all fresh sanctions or renewals in respect of unrated claims on corporates in excess of Rs.50 crore will attract a risk weight of 150 per cent. With effect from April 1, 2009, all fresh sanctions or renewals in respect of unrated claims on corporates in excess of Rs. 10 crore will attract a risk weight of 150 per cent. The threshold of Rs. 50 crore (and Rs. 10 crore) will be with reference to the aggregate exposure on a single counterparty for the bank as a whole.

5.8.3 With a view to reflect a higher element of inherent risk which may be latent in entities whose obligations have been subjected to re-structuring / re-scheduling either by the banks on their own or along with other bankers / creditors, the unrated standard / performing claims on these entities should be assigned a higher risk weight until satisfactory performance under the revised payment schedule has been established for one year from the date when the first payment of interest / principal falls due under the revised schedule. The applicable risk weights will be 125 per cent. If the claim is unrated and exceeds the limits laid down in para 5.8.2 above, the applicable risk weight will be 150 per cent.

5.8.4 The claims on non-resident corporates will be risk weighted as under as per the ratings assigned by international rating agencies. For the financial year 2008-09, all fresh sanctions or renewals in respect of unrated claims on non-resident corporates in excess of Rs.50 crore will attract a risk weight of 150 per cent. With effect from April 1, 2009, all fresh sanctions or renewals in respect of unrated claims on non-resident corporates in excess of Rs. 10 crore will attract a risk weight of 150 per cent. The threshold of Rs. 50 crore (and Rs. 10 crore) will be with reference to the aggregate exposure on a single counterparty for the bank as a whole.

Table 7: Claims on non-resident corporates – Risk weights

5.9 Claims included in the regulatory retail portfolios

5.9.1 Claims (include both fund-based and non-fund based) that meet all the four criteria listed below in paragraph 5.9.3 may be considered as retail claims for regulatory capital purposes and included in a regulatory retail portfolio. Claims included in this portfolio shall be assigned a risk-weight of 75 per cent, except as provided in paragraph 5.12 below for non performing assets.

5.9.2 The following claims, both fund based and non fund based, shall be excluded from the regulatory retail portfolio:

(a) Exposures by way of investments in securities (such as bonds and equities), whether listed or not;
(b) Mortgage loans to the extent that they qualify for treatment as claims secured by residential property or claims secured by commercial real estate;
(c) Loans and advances to bank’s own staff which are fully covered by superannuation benefits and / or mortgage of flat/ house;
(d) Consumer credit, including personal loans and credit card receivables;
(e) Capital market exposures;
(f) Venture capital funds.

5.9.3 Qualifying criteria
(i) Orientation criterion- The exposure (both fund-based and non fund-based) is to an individual person or persons or to a small business; Person under this clause would mean any legal person capable of entering into contracts and would include but not be restricted to individual, HUF, partnership firm, trust, private limited companies, public limited companies, co-operative societies etc. Small business is one where the total average annual turnover is less than Rs. 50 crore. The turnover criterion will be linked to the average of the last three years in the case of existing entities; projected turnover in the case of new entities; and both actual and projected turnover for entities which are yet to complete three years.

(ii) Product criterion - The exposure (both fund-based and non fund-based) takes the form of any of the following: revolving credits and lines of credit (including overdrafts), term loans and leases (e.g. instalment loans and leases, student and educational loans) and small business facilities and commitments.

(iii) Granularity criterion- Banks must ensure that the regulatory retail portfolio is sufficiently diversified to a degree that reduces the risks in the portfolio, warranting the 75 per cent risk weight. One way of achieving this is that no aggregate exposure to one counterpart should exceed 0.2 per cent of the overall regulatory retail portfolio. ‘Aggregate exposure’ means gross amount (i.e. not taking any benefit for credit risk mitigation into account) of all forms of debt exposures (e.g. loans or commitments) that individually satisfy the three other criteria. In addition, ‘one counterpart’ means one or several entities that may be considered as a single beneficiary (e.g. in the case of a small business that is affiliated to another small business, the limit would apply to the bank's aggregated exposure on both businesses). While banks may appropriately use the group exposure concept for computing aggregate exposures, they should evolve adequate systems to ensure strict adherence with this criterion. NPAs under retail loans are to be excluded from the overall regulatory retail portfolio when assessing the granularity criterion for risk-weighting purposes.

(iv) Low value of individual exposures - The maximum aggregated retail exposure to one counterpart should not exceed the absolute threshold limit of Rs. 5 crore.

5.9.4 For the purpose of ascertaining compliance with the absolute threshold, exposure would mean sanctioned limit or the actual outstanding, whichever is higher, for all fund based and non-fund based facilities, including all forms of off-balance sheet exposures. In the case of term loans and EMI based facilities, where there is no scope for redrawing any portion of the sanctioned amounts, exposure shall mean the actual outstanding.

Vide Sl. No.6 in the Annex to DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

Vide Sl. No.4 in the Annex to DBOD.No.BP.BC.21.06.001/2007-08 dated March 31, 2008.

Mortgage loans qualifying for treatment as ‘claims secured by residential property’ are defined in paragraph 5.10 below.

As defined in paragraph 5.11.1 below.

5.9.5 The RBI would evaluate at periodic intervals the risk weight assigned to the retail portfolio with reference to the default experience for these exposures. As part of the supervisory review process, the RBI would also consider whether the credit quality of regulatory retail claims held by individual banks should warrant a standard risk weight higher than 75 per cent.

5.10 Claims secured by residential property

5.10.1 Lending to individuals meant for acquiring residential property which are fully secured by mortgages on the residential property that is or will be occupied by the borrower, or that is rented, shall be risk weighted as indicated below, provided the loan to value ratio (LTV) is not more than 75per cent, based on Board approved valuation policy. LTV ratio should be computed as a percentage with total outstanding in the account (viz. “principal + accrued interest + other charges pertaining to the loan” without any netting) in the numerator and the realisable value of the residential property mortgaged to the bank in the denominator.

5.10.2 Lending for acquiring residential property, which meets the above criteria but have LTV ratio of more than 75 per cent, will attract a risk weight of 100 per cent.
5.10.3 All other claims secured by residential property would attract the higher of the risk weight applicable to the counterparty or to the purpose for which the bank has extended finance.
5.10.4 Loans / exposures to intermediaries for on-lending will not be eligible for inclusion under claims secured by residential property but will be treated as claims on corporates or claims included in the regulatory retail portfolio as the case may be.
5.10.5 Investments in mortgage backed securities (MBS) backed by exposures as at paragraph 5.10.1 above will be governed by the guidelines pertaining to securitisation exposures (c.f. paragraph 5.16 below).

5.11 Claims secured by commercial real estate

5.11.1 Claims secured by commercial real estate is defined as “fund based and non-fund based exposures secured by mortgages on commercial real estates (office buildings, retail space, multi-purpose commercial premises, multi-family residential buildings, multi-tenanted commercial premises, industrial or warehouse space, hotels, land acquisition, development and construction etc.)” Exposures to entities for setting up Special Economic Zones (SEZs) or for acquiring units in SEZs which includes real estate would also be treated as commercial real estate exposure.

5.11.2 Claims secured by commercial real estate as defined above will attract a risk weight of 150 per cent.

5.11.3 Investments in mortgage backed securities (MBS) backed by exposures as at paragraph 5.11.1 above will be governed by the guidelines pertaining to securitisation exposures c.f. paragraph 5.16 below.

5.12 Non-performing assets (NPAs)

5.12.1 The unsecured portion of NPA (other than a qualifying residential mortgage loan which is addressed in paragraph 5.12.6), net of specific provisions (including partial write-offs), will be risk-weighted as follows:
(i) 150 per cent risk weight when specific provisions are less than 20 per cent of the outstanding amount of the NPA ;
(ii) 100 per cent risk weight when specific provisions are at least 20 per cent of the outstanding amount of the NPA ;
(iii) 50 per cent risk weight when specific provisions are at least 50 per cent of the outstanding amount of the NPA

5.12.2 For the purpose of computing the level of specific provisions in NPAs for deciding the risk-weighting, all funded NPA exposures of a single counterparty (without netting the value of the eligible collateral) should be reckoned in the denominator.

5.12.3 For the purpose of defining the secured portion of the NPA, eligible collateral will be the same as recognised for credit risk mitigation purposes (paragraphs 7.3.5). Hence, other forms of collateral like land, buildings, plant, machinery, current assets, etc. will not be reckoned while computing the secured portion of NPAs for capital adequacy purposes.

5.12.4 In addition to the above, where a NPA is fully secured by the following forms of collateral that are not recognised for credit risk mitigation purposes, either independently or along with other eligible collateral a 100 per cent risk weight may apply, net of specific provisions, when provisions reach 15 per cent of the outstanding amount:

(i) Land and building which are valued by an expert valuer and where the valuation is not more than three years old, and

(ii Plant and machinery in good working condition at a value not higher than the depreciated value as reflected in the audited balance sheet of the borrower, which is not older than eighteen months.

5.12.5 The above collaterals (mentioned in paragraph 5.12.4) will be recognized only where the bank is having clear title to realize the sale proceeds thereof and can appropriate the same towards the amounts due to the bank. The bank’s title to the collateral should be well documented. These forms of collaterals are not recognised anywhere else under the standardised approach.

5.12.6 Claims secured by residential property, as defined in paragraph 5.10.1, which are NPA will be risk weighted at 100 per cent net of specific provisions. If the specific provisions in such loans are at least 20 per cent but less than 50 per cent of the outstanding amount, the risk weight applicable to the loan net of specific provisions will be 75 per cent. If the specific provisions are 50 per cent or more the applicable risk weight will be 50 per cent.

5.13 Specified categories

5.13.1 Fund based and non-fund based claims on the following segments which are considered as high risk exposures will attract a higher risk weight of 150 per cent:
a) Venture capital funds; and
b) Commercial real estate.

5.13.2 Reserve Bank may, in due course, decide to apply a 150 per cent or higher risk weight reflecting the higher risks associated with any other claim that may be identified as a high risk exposure.

5.13.3 Consumer credit, including personal loans and credit card receivables but excluding educational loans, will attract a higher risk weight of 125 per cent or higher, if warranted by the external rating (or, the lack of it) of the counterparty. As gold and gold jewellery are eligible financial collateral, the counterparty exposure in respect of personal loans secured by gold and gold jewellery will be worked out under the comprehensive approach as per paragraph 7.3.4. The ‘exposure value after risk mitigation’ shall attract the risk weight of 125 per cent.

5.13.4 ‘Capital market exposures’ will attract a 125 per cent risk weight or risk weight warranted by external rating (or lack of it) of the counterparty.

5.13.5 The claims on ‘Non-deposit taking systemically important non-banking financial companies (NBFC-ND-SI), other than AFCs, will attract risk weight as furnished in the Table below:

5.13.6 All investments in the paid up equity of non-financial entities, which are not consolidated for capital purposes with the bank, shall be assigned a 125 per cent risk weight.
5.13.7 All Investments in the paid up equity of financial entities (other than banks, which are covered under paragraph 5.6), which are not consolidated for capital purposes with the bank, where such investment is upto 30 per cent of the equity of the investee entity, shall be assigned a 125 per cent risk weight or a risk weight warranted by the external rating (or the lack of it) of the counterparty, whichever is higher. The investment in paid up equity of financial entities, which are specifically exempted from ‘capital market exposure’, shall be assigned a 100 percent risk weight.

5.13.8 Bank’s investments in the non-equity capital eligible instruments of other banks should be risk weighted as prescribed in paragraph 5.6.1

5.14 Other Assets

5.14.1 Loans and advances to bank’s own staff which are fully covered by superannuation benefits and/or mortgage of flat/ house will attract a 20 per cent risk weight. Since flat / house is not an eligible collateral and since banks normally recover the dues by adjusting the superannuation benefits only at the time of cessation from service, the concessional risk weight shall be applied without any adjustment of the outstanding amount. In case a bank is holding eligible collateral in respect of amounts due from a staff member, the outstanding amount in respect of that staff member may be adjusted to the extent permissible, as indicated in paragraph 7 below.
5.14.2 Other loans and advances to bank’s own staff will be eligible for inclusion under regulatory retail portfolio and will therefore attract a 75 per cent risk weight.
5.14.3 All other assets will attract a uniform risk weight of 100 per cent.

5.15 Off-balance sheet items

5.15.1 General

i) The total risk weighted off-balance sheet credit exposure is calculated as the sum of the risk-weighted amount of the market related and non-market related off-balance sheet items. The risk-weighted amount of an off-balance sheet item that gives rise to credit exposure is generally calculated by means of a two-step process:

(a) the notional amount of the transaction is converted into a credit equivalent amount, by multiplying the amount by the specified credit conversion factor or by applying the current exposure method, and

(b) the resulting credit equivalent amount is multiplied by the risk weight applicable to the counterparty or to the purpose for which the bank has extended finance or the type of asset, whichever is higher.

ii) Where the off-balance sheet item is secured by eligible collateral or guarantee, the credit risk mitigation guidelines detailed in paragraph 7 may be applied.

5.15.2 Non-market-related off balance sheet items

i) The credit equivalent amount in relation to a non-market related off-balance sheet item like, direct credit substitutes, trade and performance related contingent items and commitments with certain drawdown, other commitments, etc. will be determined by multiplying the contracted amount of that particular transaction by the relevant credit conversion factor (CCF).

ii) Where the non-market related off-balance sheet item is an undrawn or partially undrawn fund-based facility, the amount of undrawn commitment to be included in calculating the off-balance sheet non-market related credit exposures is the maximum unused portion of the commitment that could be drawn during the remaining period to maturity. Any drawn portion of a commitment forms a part of bank's on-balance sheet credit exposure.

iii) In the case of irrevocable commitments to provide off-balance sheet facilities, the original maturity will be measured from the commencement of the commitment until the time the associated facility expires. For example an irrevocable commitment with an original maturity of 12 months, to issue a 6 month documentary letter of credit, is deemed to have an original maturity of 18 months. Irrevocable commitments to provide off-balance sheet facilities should be assigned the lower of the two applicable credit conversion factors. For example, an irrevocable commitment with an original maturity of 15 months (50 per cent - CCF) to issue a six month documentary letter of credit (20 per cent - CCF) would attract the lower of the CCF i.e., the CCF applicable to the documentary letter of credit viz. 20 per cent.

iv) The credit conversion factors for non-market related off-balance sheet transactions are as under:

Vide circular DBOD.No.BP.BC.83/21.06.001/2007-08 dated May 14, 2008

Vide Sl No.7 in the Annex to DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

For example: (a) In the case of a cash credit facility for Rs.100 lakh (which is not unconditionally cancellable) where the drawn portion is Rs. 60 lakh, the undrawn portion of Rs. 40 lakh will attract a CCF of 20 per cent (since the CC facility is subject to review / renewal normally once a year). The credit equivalent amount of Rs. 8 lakh (20 % of Rs.40 lakh) will be assigned the appropriate risk weight as applicable to the counterparty / rating to arrive at the risk weighted asset for the undrawn portion. The drawn portion (Rs. 60 lakh) will attract a risk weight as applicable to the counterparty / rating.

(b) A TL of Rs. 700 cr is sanctioned for a large project which can be drawn down in stages over a three year period. The terms of sanction allow draw down in three stages – Rs. 150 cr in Stage I, Rs. 200 cr in Stage II and Rs. 350 cr in Stage III, where the borrower needs the bank’s explicit approval for draw down under Stages II and III after completion of certain formalities. If the borrower has drawn already Rs. 50 cr under Stage I, then the undrawn portion would be computed with reference to Stage I alone i.e., it will be Rs.100 cr. If Stage I is scheduled to be completed within one year, the CCF will be 20% and if it is more than one year then the applicable CCF will be 50 per cent.

Table 8: Credit conversion factors – Non-market related off-balance sheet items

Pl. refer to item (a) of Sl.No.19 in the Annex to DBOD.No.BP.BC.67/21.06.001/2007-08 dt. March 31, 2008

v) In regard to non-market related off-balance sheet items, the following transactions with non-bank counterparties will be treated as claims on banks:

• Guarantees issued by banks against the counter guarantees of other banks.
• Rediscounting of documentary bills discounted by other banks andbills discounted by banks which have been accepted by another bank will be treated as a funded claim on a bank.

In all the above cases banks should be fully satisfied that the risk exposure is in fact on the other bank. If they are satisfied that the exposure is on the other bank they may assign these exposures the risk weight applicable to banks as detailed in paragraph 5.6.

5.15.3 Market related off-balance sheet items

i) In calculating the risk weighted off-balance sheet credit exposures arising from market related off-balance sheet items for capital adequacy purposes, the bank should include all its market related transactions held in the banking and trading book which give rise to off-balance sheet credit risk.
ii) The credit risk on market related off-balance sheet items is the cost to a bank of replacing the cash flow specified by the contract in the event of counterparty default. This would depend, among other things, upon the maturity of the contract and on the volatility of rates underlying the type of instrument.

iii) Market related off-balance sheet items would include:

.a) interest rate contracts – including single currency interest rate swaps, basis swaps, forward rate agreements, and interest rate futures;
.b) foreign exchange contracts, including contracts involving gold, – includes cross currency swaps (including cross currency interest rate swaps), forward foreign exchange contracts, currency futures, currency options;
.c) any other market related contracts specifically allowed by the Reserve Bank which give rise to credit risk.

iv) Exemption from capital requirements is permitted for

a) foreign exchange (except gold) contracts which have an original maturity of 14 calendar days or less; and

b) instruments traded on futures and options exchanges which are subject to daily mark-to-market and margin payments.
v) The credit equivalent amount of a market related off-balance sheet item, whether held in the banking book or trading book must be determined by the current exposure method.

5.15.4 Current Exposure Method

i) The credit equivalent amount of a market related off-balance sheet transaction calculated using the current exposure method is the sum of current credit exposure and potential future credit exposure of these contracts.
ii) Current credit exposure is defined as the sum of the positive mark-to-market value of these contracts. The Current Exposure Method requires periodical calculation of the current credit exposure by marking these contracts to market, thus capturing the current credit exposure.
iii) Potential future credit exposure is determined by multiplying the notional principal amount of each of these contracts irrespective of whether the contract has a zero, positive or negative mark-to-market value by the relevant add-on factor indicated below according to the nature and residual maturity of the instrument.

Table 9 : Credit Conversion Factors for market related off-balance sheet items

iv) For contracts with multiple exchanges of principal, the add-on factors are to be multiplied by the number of remaining payments in the contract.

v) For contracts that are structured to settle outstanding exposure following specified payment dates and where the terms are reset such that the market value of the contract is zero on these specified dates, the residual maturity would be set equal to the time until the next reset date. In the case of interest rate contracts with remaining maturities of more than one year that meet the above criteria, the add-on factor is subject to a floor of 0.5 per cent.

vi) No potential future credit exposure would be calculated for single currency floating/floating interest rate swaps; the credit exposure on these contracts would be evaluated solely on the basis of their mark-to-market value.

vii) Potential future exposures should be based on effective rather than apparent notional amounts. In the event that the stated notional amount is leveraged or enhanced by the structure of the transaction, banks must use the effective notional amount when determining potential future exposure. For example, a stated notional amount of USD 1 million with payments based on an internal rate of two times the BPLR would have an effective notional amount of USD 2 million.

5.15.5 Failed transactions

i) With regard to unsettled securities and foreign exchange transactions, banks are exposed to counterparty credit risk from trade date, irrespective of the booking or the accounting of the transaction. Banks are encouraged to develop, implement and improve systems for tracking and monitoring the credit risk exposure arising from unsettled transactions as appropriate for producing management information that facilitates action on a timely basis.

ii) Banks must closely monitor securities and foreign exchange transactions that have failed, starting from the day they fail for producing management information that facilitates action on a timely basis. Failed transactions give rise to risk of delayed settlement or delivery.

iii) Failure of transactions settled through a delivery-versus-payment system (DvP), providing simultaneous exchanges of securities for cash, expose banks to a risk of loss on the difference between the transaction valued at the agreed settlement price and the transaction valued at current market price (i.e. positive current exposure). Failed transactions where cash is paid without receipt of the corresponding receivable (securities, foreign currencies, or gold,) or, conversely, deliverables were delivered without receipt of the corresponding cash payment (non-DvP, or free-delivery) expose banks to a risk of loss on the full amount of cash paid or deliverables delivered. Therefore, a capital charge is required for failed transactions and must be calculated as under. The following capital treatment is applicable to all failed transactions, including transactions through recognised clearing houses. Repurchase and reverse-repurchase agreements as well as securities lending and borrowing that have failed to settle are excluded from this capital treatment.

Pl. refer to item (b) of Sl.No.19 of DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

Pl. refer to Sl. No.8 in the Annex to DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008.

iv) For DvP Transactions – If the payments have not yet taken place five business days after the settlement date, banks are required to calculate a capital charge by multiplying the positive current exposure of the transaction by the appropriate factor as under. In order to capture the information, banks will need to upgrade their information systems in order to track the number of days after the agreed settlement date and calculate the corresponding capital charge.

v) For non-DvP transactions (free deliveries) after the first contractual payment / delivery leg, the bank that has made the payment will treat its exposure as a loan if the second leg has not been received by the end of the business day. If the dates when two payment legs are made are the same according to the time zones where each payment is made, it is deemed that they are settled on the same day. For example, if a bank in Tokyo transfers Yen on day X (Japan Standard Time) and receives corresponding US Dollar via CHIPS on day X (US Eastern Standard Time), the settlement is deemed to take place on the same value date. Banks shall compute the capital requirement using the counterparty risk weights prescribed in these guidelines. However, if five business days after the second contractual payment / delivery date the second leg has not yet effectively taken place, the bank that has made the first payment leg will deduct from capital the full amount of the value transferred plus replacement cost, if any. This treatment will apply until the second payment / delivery leg is effectively made.

5.16 Securitisation Exposures

5.16.1 General

i) A securitisation transaction, which meets the minimum requirements, listed in Annex 6 (extracted from the ‘Guidelines on Securitisation of Standard Assets’, issued vide circular DBOD.No.BP.BC.60/ 21.04.048/ 2005-06 dated February 1, 2006), would qualify for the following prudential treatment of securitisation exposures for capital adequacy purposes. Banks’ exposures to a securitisation transaction, referred to as securitisation exposures, can include, but are not restricted to the following: as investor, as credit enhancer, as liquidity provider, as underwriter, as provider of credit risk mitigants. Cash collaterals provided as credit enhancements shall also be treated as securitisation exposures. The terms used in this section with regard to securitisation shall be as defined in the above guidelines. Further, the following definitions shall be applicable:

a) A ‘credit enhancing interest only strip (I/Os)’ – an on-balance sheet exposure that is recorded by the originator, which (i) represents a valuation of cash flows related to future margin income to be derived from the underlying exposures, and (ii) is subordinated to the claims of other parties to the transaction in terms of priority of repayment.
b) ‘Implicit support’ – the support provided by a bank to a securitisation in excess of its predetermined contractual obligation.
c) A ‘gain-on-sale’ – any profit realised at the time of sale of the securitised assets to SPV.

ii) Banks are required to hold regulatory capital against all of their securitisation exposures, including those arising from the provision of credit risk mitigants to a securitisation transaction, investments in asset-backed securities, retention of a subordinated tranche, and extension of a liquidity facility or credit enhancement, as set forth in the following paragraphs. Repurchased securitisation exposures must be treated as retained securitisation exposures. .

iii) An originator in a securitisation transaction which does not meet the minimum requirements prescribed in the guidelines dated February 1, 2006 and therefore does not qualify for de-recognition shall hold capital against all of the exposures associated with the securitisation transaction as if they had not been securitised. Additionally, the originator shall deduct any ‘gain on sale’ on such transaction from Tier 1 capital.

5.16.2 Deduction of securitisation exposures from capital funds

i) When a bank is required to deduct a securitisation exposure from regulatory capital, the deduction must be made 50 per cent from Tier 1 and 50 per cent from Tier 2, except where expressly provided otherwise. Deductions from capital may be calculated net of any specific provisions maintained against the relevant securitisation exposures.

ii) Credit enhancements, including credit enhancing I/Os (net of the gain-on-sale that shall be deducted from Tier 1 as specified below) and cash collaterals, which are required to be deducted must be deducted 50 per cent from Tier 1 and 50 per cent from Tier 2.

iii) Banks shall deduct from Tier 1 capital any “gain-on-sale”, if permitted to be recognised. However, in terms of guidelines on securitisation of standard assets, banks are allowed to amortise the profit over the period of the securities issued by the SPV. The amount of profit thus recognised in the P & L Account through amortisation, need not be deducted.

.iv) Any rated securitisation exposure with a long term rating of ‘B+ and below’ when not held by an originator, and a long term rating of ‘BB+ and below’ when held by the originator shall be deducted 50 per cent from Tier 1 and 50 per cent from Tier 2 capital.

v) Any unrated securitisation exposure, except an eligible liquidity facility as specified in paragraph 5.16.8 should be deducted 50 per cent from Tier 1 and 50 per cent from Tier 2 capital. In an unrated and ineligible liquidity facility, both the drawn and undrawn portions shall be deducted 50 per cent from Tier 1 and 50 per cent from Tier 2 capital.

vi) The holdings of securities devolved on the originator through underwriting should be sold to third parties within three-month period following the acquisition. In case of failure to off-load within the stipulated time limit, any holding in excess of 20 per cent of the original amount of issue, including secondary market purchases, shall be deducted 50 per cent from Tier 1 and 50 per cent from Tier 2 capital.

5.16.3 Implicit support

i) The originator shall not provide any implicit support to investors in a securitisation transaction.

ii) When a bank is deemed to have provided implicit support to a securitisation:
a) It must, at a minimum, hold capital against all of the exposures associated with the securitisation transaction as if they had not been securitised.
b) Additionally, the bank would need to deduct any gain-on-sale, as defined above, from Tier 1 capital.
c) Furthermore, in respect of securitisation transactions where the bank is deemed to have provided implicit support it is required to disclose publicly that (a) it has provided non-contractual support (b) the details of the implicit support and (c) the impact of the implicit support on the bank’s regulatory capital.

iii) Where a securitisation transaction contains a clean up call and the clean up call can be exercised by the originator in circumstances where exercise of the clean up call effectively provides credit enhancement, the clean up call shall be treated as implicit support and the concerned securitisation transaction will attract the above prescriptions.

5.16.4 Application of external ratings

The following operational criteria concerning the use of external credit assessments apply:
i) A bank must apply external credit assessments from eligible external credit rating agencies consistently across a given type of securitisation exposure. Furthermore, a bank cannot use the credit assessments issued by one external credit rating agency for one or more tranches and those of another external credit rating agency for other positions (whether retained or purchased) within the same securitisation structure that may or may not be rated by the first external credit rating agency. Where two or more eligible external credit rating agencies can be used and these assess the credit risk of the same securitisation exposure differently, paragraphs 6.7 will apply.

ii) If the CRM provider is not recognised as an eligible guarantor as defined in paragraph 7.5.5, the covered securitisation exposures should be treated as unrated.

iii) In the situation where a credit risk mitigant is not obtained by the SPV but rather applied to a specific securitisation exposure within a given structure (e.g. ABS tranche), the bank must treat the exposure as if it is unrated and then use the CRM treatment outlined in paragraph 7.

iv) The other aspects of application of external credit assessments will be as per guidelines given in paragraph 6.

5.16.5 Risk weighted securitisation exposures

i) Banks shall calculate the risk weighted amount of an on-balance sheet securitisation exposure by multiplying the principal amount (after deduction of specific provisions) of the exposures by the applicable risk weight.

ii) The risk-weighted asset amount of a securitisation exposure is computed by multiplying the amount of the exposure by the appropriate risk weight determined in accordance with issue specific rating assigned to those exposures by the chosen external credit rating agencies as indicated in the following tables:

Table 10: Securitisation exposures – Risk weight mapping to long-term ratings

* governed by the provisions of paragraph5.16.2
iii) The risk-weighted asset amount of a securitisation exposure in respect of MBS backed by commercial real estate exposure, as defined in paragraph 5.11 above, is computed by multiplying the amount of the exposure by the appropriate risk weight determined in accordance with issue specific rating assigned to those exposures by the chosen external credit rating agencies as indicated in the following tables:

Table 11: Commercial real estate securitisation exposures –
Risk weight mapping to long-term ratings

* governed by the provisions of paragraph 5.16.2

For example: If in a securitisation transa

ction of Rs.100, the pool consists of 80 per cent of AAA securities, 10 per cent of BB securities and 10 per cent of unrated securities and the transaction does not meet the true sale criterion, then the originator will be deemed to be holding all the exposures in that transaction. Consequently, the AAA rated securities will attract a risk weight of 20 per cent and the face value of the BB rated securities and the unrated securities will be deducted. Thus the consequent impact on the capital will be Rs.21.44 (16*9 % + 20).

Vide item (c) of Sl.No.19 in the Annex to DBOD.No.BP.BC.21.06.001/2007-08 dated March 31, 2008

Vide item (d) of Sl. No.19 in the Annex to DBOD.No.BP.BC.21.06.001/2007-08 dated March 31, 2008

v) Banks are not permitted to invest in unrated securities issued by an SPV as a part of the securitisation transaction. However, securitisation exposures assumed by banks which may become unrated or may be deemed to be unrated, would be deducted for capital adequacy purposes in accordance with the provisions of paragraph 5.16.2.

5.16.6 Off-balance sheet securitisation exposures

i) Banks shall calculate the risk weighted amount of a rated off-balance sheet securitisation exposure by multiplying the credit equivalent amount of the exposure by the applicable risk weight. The credit equivalent amount should be arrived at by multiplying the principal amount of the exposure (after deduction of specific provisions) with a 100 per cent CCF, unless otherwise specified.
ii) If the off-balance sheet exposure is not rated, it must be deducted from capital, except an unrated eligible liquidity facility for which the treatment has been specified separately in paragraph 5.16.8.

5.16.7 Recognition of credit risk mitigants

i) The treatment below applies to a bank that has obtained a credit risk mitigant on a securitisation exposure. Credit risk mitigant include guarantees and eligible collateral as specified in these guidelines. Collateral in this context refers to that used to hedge the credit risk of a securitisation exposure rather than for hedging the credit risk of the underlying exposures of the securitisation transaction.

ii) When a bank other than the originator provides credit protection to a securitisation exposure, it must calculate a capital requirement on the covered exposure as if it were an investor in that securitisation. If a bank provides protection to an unrated credit enhancement, it must treat the credit protection provided as if it were directly holding the unrated credit enhancement.

iii) Capital requirements for the guaranteed / protected portion will be calculated according to CRM methodology for the standardised approach as specified in paragraph 7 below. Eligible collateral is limited to that recognised under these guidelines in paragraph 7.3.5. For the purpose of setting regulatory capital against a maturity mismatch between the CRM and the exposure, the capital requirement will be determined in accordance with paragraphs 7.6. When the exposures being hedged have different maturities, the longest maturity must be used applying the methodology prescribed in paragraphs 7.6.3 & 7.6.4.

5.16.8 Liquidity facilities

i) A liquidity facility will be considered as an ‘eligible’ facility only if it satisfies all minimum requirements prescribed in the guidelines issued on February 1, 2006. The rated liquidity facilities will be risk weighted or deducted as per the appropriate risk weight determined in accordance with the specific rating assigned to those exposures by the chosen ECAIs as indicated in the tables presented above.

ii) The unrated eligible liquidity facilities will be exempted from deductions and treated as follows.

a) The drawn and undrawn portions of an unrated eligible liquidity facility would attract a risk weight equal to the highest risk weight assigned to any of the underlying individual exposures covered by this facility.

b) The undrawn portion of an unrated eligible liquidity will attract the following credit conversion factors for calculating the credit equivalent amount: :

i) 20 per cent for facilities with an original maturity of one year or less, or

ii) 50 per cent for facilities with an original maturity of more than one year.

6. External credit assessments

6.1 Eligible Credit Rating Agencies

6.1.1 Reserve Bank has undertaken the detailed process of identifying the eligible credit rating agencies, whose ratings may be used by banks for assigning risk weights for credit risk. In line with the provisions of the Revised Framework, where the facility provided by the bank possesses rating assigned by an eligible credit rating agency, the risk weight of the claim will be based on this rating.

6.1.2 In accordance with the principles laid down in the Revised Framework, the Reserve Bank of India has decided that banks may use the ratings of the following domestic credit rating agencies (arranged in alphabetical order) for the purposes of risk weighting their claims for capital adequacy purposes:

a) Credit Analysis and Research Limited;
b) CRISIL Limited;
c) FITCH India; and
d) ICRA Limited.
6.1.2.1 The Reserve Bank of India has decided that banks may use the ratings of the following international credit rating agencies (arranged in alphabetical order) for the purposes of risk weighting their claims for capital adequacy purposes where specified:
a) Fitch;
b) Moodys; and
c) Standard & Poor’s

6.2 Scope of application of external ratings

6.2.1 Banks should use the chosen credit rating agencies and their ratings consistently for each type of claim, for both risk weighting and risk management purposes. Banks will not be allowed to “cherry pick” the assessments provided by different credit rating agencies. If a bank has decided to use the ratings of some of the chosen credit rating agencies for a given type of claim, it can use only the ratings of those credit rating agencies, despite the fact that some of these claims may be rated by other chosen credit rating agencies whose ratings the bank has decided not to use Banks shall not use one agency’s rating for one corporate bond, while using another agency’s rating for another exposure to the same counter-party, unless the respective exposures are rated by only one of the chosen credit rating agencies, whose ratings the bank has decided to use. External assessments for one entity within a corporate group cannot be used to risk weight other entities within the same group.

6.2.2 Banks must disclose the names of the credit rating agencies that they use for the risk weighting of their assets, the risk weights associated with the particular rating grades as determined by Reserve Bank through the mapping process for each eligible credit rating agency as well as the aggregated risk weighted assets as required vide Table DF-5.

6.2.3 To be eligible for risk-weighting purposes, the external credit assessment must take into account and reflect the entire amount of credit risk exposure the bank has with regard to all payments owed to it. For example, if a bank is owed both principal and interest, the assessment must fully take into account and reflect the credit risk associated with timely repayment of both principal and interest.

6.2.4 To be eligible for risk weighting purposes, the rating should be in force and confirmed from the monthly bulletin of the concerned rating agency. The rating agency should have reviewed the rating at least once during the previous 15 months.

6.2.5 An eligible credit assessment must be publicly available. In other words, a rating must be published in an accessible form and included in the external credit rating agency’s transition matrix. Consequently, ratings that are made available only to the parties to a transaction do not satisfy this requirement.

6.2.6 For assets in the bank’s portfolio that have contractual maturity less than or equal to one year, short term ratings accorded by the chosen credit rating agencies would be relevant. For other assets which have a contractual maturity of more than one year, long term ratings accorded by the chosen credit rating agencies would be relevant.

6.2.7 Cash credit exposures tend to be generally rolled over and also tend to be drawn on an average for a major portion of the sanctioned limits. Hence, even though a cash credit exposure may be sanctioned for period of one year or less, these exposures should be reckoned as long term exposures and accordingly the long term ratings accorded by the chosen credit rating agencies will be relevant. Similarly, banks may use long-term ratings of a counterparty as a proxy for an unrated short- term exposure on the same counterparty subject to strict compliance with the requirements for use of multiple rating assessments and applicability of issue rating to issuer / other claims as indicated in paragraphs 6.4, 6.5, 6.7 and 6.8 below.

6.3 Mapping process

The Revised Framework recommends development of a mapping process to assign the ratings issued by eligible credit rating agencies to the risk weights available under the Standardised risk weighting framework. The mapping process is required to result in a risk weight assignment consistent with that of the level of credit risk. A mapping of the credit ratings awarded by the chosen domestic credit rating agencies has been furnished below in paragraphs 6.4.1 and 6.5.4, which should be used by banks in assigning risk weights to the various exposures.

6.4 Long term ratings

6.4.1 On the basis of the above factors as well as the data made available by the rating agencies, the ratings issued by the chosen domestic credit rating agencies have been mapped to the appropriate risk weights applicable as per the Standardised approach under the Revised Framework. The rating-risk weight mapping furnished in the Table below shall be adopted by all banks in India:
Table 12: Risk weight mapping of Long term Ratings of the chosen domestic rating agencies

6.4.2 Where “+” or “-” notation is attached to the rating, the corresponding main rating category risk weight should be used. For example, A+ or A- would be considered to be in the A rating category and assigned 50 per cent risk weight.
6.4.3 If an issuer has a long-term exposure with an external long term rating that warrants a risk weight of 150 per cent, all unrated claims on the same counter-party, whether short-term or long-term, should also receive a 150 per cent risk weight, unless the bank uses recognised credit risk mitigation techniques for such claims.

6.5 Short term ratings

6.5.1 For risk-weighting purposes, short-term ratings are deemed to be issue-specific. They can only be used to derive risk weights for claims arising from the rated facility. They cannot be generalised to other short-term claims. In no event can a short-term rating be used to support a risk weight for an unrated long-term claim. Short-term assessments may only be used for short-term claims against banks and corporates.

6.5.2 Notwithstanding the above restriction on using an issue specific short term rating for other short term exposures, the following broad principles will apply. The unrated short term claim on counterparty will attract a risk weight of at least one level higher than the risk weight applicable to the rated short term claim on that counter-party. If a short-term rated facility to counterparty attracts a 20 per cent or a 50 per cent risk-weight, unrated short-term claims to the same counter-party cannot attract a risk weight lower than 30 per cent or 100 per cent respectively.

6.5.3 Similarly, if an issuer has a short-term exposure with an external short term rating that warrants a risk weight of 150 per cent, all unrated claims on the same counter-party, whether long-term or short-term, should also receive a 150 per cent risk weight, unless the bank uses recognised credit risk mitigation techniques for such claims.

6.5.4 In respect of the issue specific short term ratings the following risk weight mapping shall be adopted by banks:

Table 13: Risk weight mapping of Short term ratings
of the domestic rating agencies

6.5.5 Where “+” or “-” notation is attached to the rating, the corresponding main rating category risk weight should be used for PR2/ P2/ F2/ A2 and below, unless specified otherwise. For example, P2+ or P2- would be considered to be in the P2 rating category and assigned 50 per cent risk weight.

6.5.6 The above risk weight mapping of both long term and short term ratings of the chosen domestic rating agencies would be reviewed annually by the Reserve Bank.

6.6 Use of unsolicited ratings

A rating would be treated as solicited only if the issuer of the instrument has requested the credit rating agency for the rating and has accepted the rating assigned by the agency. As a general rule, banks should use only solicited rating from the chosen credit rating agencies. No ratings issued by the credit rating agencies on an unsolicited basis should be considered for risk weight calculation as per the Standardised Approach.

6.7 Use of multiple rating assessments

Banks shall be guided by the following in respect of exposures / obligors having multiple ratings from the chosen credit rating agencies chosen by the bank for the purpose of risk weight calculation:

(i) If there is only one rating by a chosen credit rating agency for a particular claim, that rating would be used to determine the risk weight of the claim.

(ii) If there are two ratings accorded by chosen credit rating agencies that map into different risk weights, the higher risk weight should be applied.

(iii) If there are three or more ratings accorded by chosen credit rating agencies with different risk weights, the ratings corresponding to the two lowest risk weights should be referred to and the higher of those two risk weights should be applied. i.e., the second lowest risk weight.

6.8 Applicability of issue rating to issuer/ other claims

Where a bank invests in a particular issue that has an issue specific rating by a chosen credit rating agency the risk weight of the claim will be based on this assessment. Where the bank’s claim is not an investment in a specific assessed issue, the following general principles will apply:

(i) In circumstances where the borrower has a specific assessment for an issued debt - but the bank’s claim is not an investment in this particular debt - the rating applicable to the specific debt (where the rating maps into a risk weight lower than that which applies to an unrated claim) may be applied to the bank’s unassessed claim only if this claim ranks pari passu or senior to the specific rated debt in all respects and the maturity of the unassessed claim is not later than the maturity of the rated claim, except where the rated claim is a short term obligation as specified in paragraph 6.5.2. If not, the rating applicable to the specific debt cannot be used and the unassessed claim will receive the risk weight for unrated claims.

(ii) If either the issuer or single issue has been assigned a rating which maps into a risk weight equal to or higher than that which applies to unrated claims, a claim on the same counterparty, which is unrated by any chosen credit rating agency, will be assigned the same risk weight as is applicable to the rated exposure, if this claim ranks pari passu or junior to the rated exposure in all respects.

(iii) Where a bank intends to extend an issuer or an issue specific rating assigned by a chosen credit rating agency to any other exposure which the bank has on the same counterparty and which meets the above criterion, it should be extended to the entire amount of credit risk exposure the bank has with regard to that exposure i.e., both principal and interest.

(iv) With a view to avoiding any double counting of credit enhancement factors, no recognition of credit risk mitigation techniques should be taken into account if the credit enhancement is already reflected in the issue specific rating accorded by a chosen credit rating agency relied upon by the bank.

(v) Where unrated exposures are risk weighted based on the rating of an equivalent exposure to that borrower, the general rule is that foreign currency ratings would be used only for exposures in foreign currency.

7. Credit Risk Mitigation

7.1 General principles

7.1.1 Banks use a number of techniques to mitigate the credit risks to which they are exposed. For example, exposures may be collateralised in whole or in part by cash or securities, deposits from the same counterparty, guarantee of a third party, etc. The revised approach to credit risk mitigation allows a wider range of credit risk mitigants to be recognised for regulatory capital purposes than is permitted under the 1988 Framework provided these techniques meet the requirements for legal certainty as described in paragraph 7.2 below. Credit risk mitigation approach as detailed in this section is applicable to the banking book exposures. This will also be applicable for calculation of the counterparty risk charges for OTC derivatives and repo-style transactions booked in the trading book.

7.1.2 The general principles applicable to use of credit risk mitigation techniques are as under:

(i) No transaction in which Credit Risk Mitigation (CRM) techniques are used should receive a higher capital requirement than an otherwise identical transaction where such techniques are not used.

(ii) The effects of CRM will not be double counted. Therefore, no additional supervisory recognition of CRM for regulatory capital purposes will be granted on claims for which an issue-specific rating is used that already reflects that CRM.

(iii) Principal-only ratings will not be allowed within the CRM framework.

(iv) While the use of CRM techniques reduces or transfers credit risk, it simultaneously may increase other risks (residual risks). Residual risks include legal, operational, liquidity and market risks. Therefore, it is imperative that banks employ robust procedures and processes to control these risks, including strategy; consideration of the underlying credit; valuation; policies and procedures; systems; control of roll-off risks; and management of concentration risk arising from the bank’s use of CRM techniques and its interaction with the bank’s overall credit risk profile. Where these risks are not adequately controlled, Reserve Bank may impose additional capital charges or take other supervisory actions. The disclosure requirements prescribed inTable DF-6 (paragraph 10 – Market Discipline) must also be observed for banks to obtain capital relief in respect of any CRM techniques.

7.2 Legal Certainty

In order for banks to obtain capital relief for any use of CRM techniques, the following minimum standards for legal documentation must be met. All documentation used in collateralised transactions and guarantees must be binding on all parties and legally enforceable in all relevant jurisdictions. Banks must have conducted sufficient legal review, which should be well documented, to verify this. Such verification should have a well founded legal basis for reaching the conclusion about the binding nature and enforceability of the documents. Banks should also undertake such further review as necessary to ensure continuing enforceability.

7.3 Credit risk mitigation techniques - Collateralised transactions

7.3.1 A collateralised transaction is one in which:

(i) banks have a credit exposure and that credit exposure is hedged in whole or in part by collateral posted by a counterparty or by a third party on behalf of the counterparty. Here, “counterparty” is used to denote a party to whom a bank has an on- or off-balance sheet credit exposure.

(ii) banks have a specific lien on the collateral and the requirements of legal certainty are met.

7.3.2 Overall framework and minimum conditions

The Revised Framework allows banks to adopt either the simple approach, which, similar to the 1988 Accord, substitutes the risk weighting of the collateral for the risk weighting of the counterparty for the collateralised portion of the exposure (generally subject to a 20 per cent floor), or the comprehensive approach, which allows fuller offset of collateral against exposures, by effectively reducing the exposure amount by the value ascribed to the collateral. Banks in India shall adopt the Comprehensive Approach, which allows fuller offset of collateral against exposures, by effectively reducing the exposure amount by the value ascribed to the collateral. Under this approach, banks, which take eligible financial collateral (e.g., cash or securities, more specifically defined below), are allowed to reduce their credit exposure to a counterparty when calculating their capital requirements to take account of the risk mitigating effect of the collateral. Credit risk mitigation is allowed only on an account-by-account basis, even within regulatory retail portfolio. However, before capital relief will be granted the standards set out below must be met:

(i) In addition to the general requirements for legal certainty, the legal mechanism by which collateral is pledged or transferred must ensure that the bank has the right to liquidate or take legal possession of it, in a timely manner, in the event of the default, insolvency or bankruptcy (or one or more otherwise-defined credit events set out in the transaction documentation) of the counterparty (and, where applicable, of the custodian holding the collateral). Furthermore banks must take all steps necessary to fulfill those requirements under the law applicable to the bank’s interest in the collateral for obtaining and maintaining an enforceable security interest, e.g. by registering it with a registrar.

(ii) In order for collateral to provide protection, the credit quality of the counterparty and the value of the collateral must not have a material positive correlation. For example, securities issued by the counterparty - or by any related group entity - would provide little protection and so would be ineligible.

(iii) Banks must have clear and robust procedures for the timely liquidation of collateral to ensure that any legal conditions required for declaring the default of the counterparty and liquidating the collateral are observed, and that collateral can be liquidated promptly.

(iv) Where the collateral is held by a custodian, banks must take reasonable steps to ensure that the custodian segregates the collateral from its own assets.

7.3.3 A capital requirement will be applied to a bank on either side of the collateralised transaction: for example, both repos and reverse repos will be subject to capital requirements. Likewise, both sides of securities lending and borrowing transactions will be subject to explicit capital charges, as will the posting of securities in connection with a derivative exposure or other borrowing.

7.3.4 The comprehensive approach

i) In the comprehensive approach, when taking collateral, banks will need to calculate their adjusted exposure to a counterparty for capital adequacy purposes in order to take account of the effects of that collateral. Banks are required to adjust both the amount of the exposure to the counterparty and the value of any collateral received in support of that counterparty to take account of possible future fluctuations in the value of either, occasioned by market movements. These adjustments are referred to as ‘haircuts’. The application of haircuts will produce volatility adjusted amounts for both exposure and collateral. The volatility adjusted amount for the exposure will be higher than the exposure and the volatility adjusted amount for the collateral will be lower than the collateral, unless either side of the transaction is cash. In other words, the ‘haircut’ for the exposure will be a premium factor and the ‘haircut’ for the collateral will be a discount factor. It may be noted that the purpose underlying the application of haircut is to capture the market-related volatility inherent in the value of exposures as well as of the eligible financial collaterals. Since the value of credit exposures acquired by the banks in the course of their banking operations, would not be subject to market volatility, (since the loan disbursal / investment would be a “cash” transaction) though the value of eligible financial collateral would be, the haircut stipulated in Table-14 would apply in respect of credit transactions only to the eligible collateral but not to the credit exposure of the bank. On the other hand, exposures of banks, arising out of repo-style transactions would require upward adjustment for volatility, as the value of security sold/lent/pledged in the repo transaction, would be subject to market volatility. Hence, such exposures shall attract haircut.

ii) Additionally where the exposure and collateral are held in different currencies an additional downwards adjustment must be made to the volatility adjusted collateral amount to take account of possible future fluctuations in exchange rates.

iii) Where the volatility-adjusted exposure amount is greater than the volatility-adjusted collateral amount (including any further adjustment for foreign exchange risk), banks shall calculate their risk-weighted assets as the difference between the two multiplied by the risk weight of the counterparty. The framework for performing calculations of capital requirement is indicated in paragraph 7.3.6.

7.3.5 Eligible financial collateral
The following collateral instruments are eligible for recognition in the comprehensive approach:
(i) Cash (as well as certificates of deposit or comparable instruments, including fixed deposit receipts, issued by the lending bank) on deposit with the bank which is incurring the counterparty exposure.

(ii) Gold: Gold would include both bullion and jewellery. However, the value of the collateralised jewellery should be arrived at after notionally converting these to 99.99 purity.

(iii) Securities issued by Central and State Governments

(iv) Kisan Vikas Patra and National Savings Certificates provided no lock-in period is operational and if they can be encashed within the holding period.

(v) Life insurance policies with a declared surrender value of an insurance company which is regulated by an insurance sector regulator.

(vi) Debt securities rated by a chosen Credit Rating Agency in respect of which the banks should be sufficiently confident about the market liquidity where these are either:
a) Attracting 100 per cent or lesser risk weight i.e., rated at least BBB(-)
when issued by public sector entities and other entities (including banks and Primary Dealers); or

b) Attracting 100 per cent or lesser risk weight i.e., rated at least PR3 /
P3/F3/A3 for short-term debt instruments.

(vii Debt securities not rated by a chosen Credit Rating Agency in respect of which the banks should be sufficiently confident about the market liquidity where these are:
a) issued by a bank; and
b) listed on a recognised exchange; and
c) classified as senior debt; and
d) all rated issues of the same seniority by the issuing bank are rated at least BBB(-) or PR3/P3/F3/A3 by a chosen Credit Rating Agency; and
e) the bank holding the securities as collateral has no information to suggest that the issue justifies a rating below BBB(-) or PR3/P3/F3/A3 (as applicable) and;
f) Banks should be sufficiently confident about the market liquidity of the security.
viii) Units of Mutual Funds regulated by the securities regulator of the jurisdiction of the bank’s operation mutual funds where:
a) a price for the units is publicly quoted daily i.e., where the daily NAV is available in public domain; and
b) Mutual fund is limited to investing in the instruments listed in this paragraph.

7.3.6 Calculation of capital requirement
For a collateralised transaction, the exposure amount after risk mitigation is calculated as follows:
E* = max {0, [E x (1 + He) - C x (1 - Hc - Hfx)]}
where:
E* = the exposure value after risk mitigation
E = current value of the exposure for which the collateral qualifies as a risk
mitigant
He = haircut appropriate to the exposure
C = the current value of the collateral received
Hc = haircut appropriate to the collateral
Hfx = haircut appropriate for currency mismatch between the collateral and exposure
The exposure amount after risk mitigation (i.e., E*) will be multiplied by the risk weight of the counterparty to obtain the risk-weighted asset amount for the collateralised transaction. Illustrative examples calculating the effect of Credit Risk Mitigation is furnished in Annex 8

7.3.7 Haircuts
i) In principle, banks have two ways of calculating the haircuts:
(i) standard supervisory haircuts, using parameters set by the Basel Committee, and
(ii) own-estimate haircuts, using banks’ own internal estimates of market price volatility. Banks in India shall use only the standard supervisory haircuts for both the exposure as well as the collateral.

ii) The Standard Supervisory Haircuts (assuming daily mark-to-market, daily re-margining and a 10 business-day holding period) , expressed as percentages, would be as furnished in Table 14.

iii) The ratings indicated in Table – 14 represent the ratings assigned by the domestic rating agencies. In the case of exposures toward debt securities issued by foreign Central Governments and foreign corporates, the haircut may be based on ratings of the international rating agencies, as indicated in Table 15.

iv) Sovereign will include Reserve Bank of India, DICGC and CGTSI, which are eligible for zero per cent risk weight.

Banks may apply a zero haircut for eligible collateral where it is a National Savings Certificate, Kisan Vikas Patras, surrender value of insurance policies and banks’ own deposits.

vi) The standard supervisory haircut for currency risk where exposure and collateral are denominated in different currencies is eight per cent (also based on a 10-business day holding period and daily mark-to-market)

In a case where a short term claim on a counterparty is rated as P1+ and a long term claim on the same counterparty is rated as AAA, then a bank may assign a 30 per cent risk weight to an unrated short term claim and 20 per cent risk weight to an unrated long term claim on that counterparty where the seniority of the claim ranks pari-passu with the rated claims and the maturity of the unrated claim is not later than the rated claim. In a similar case where a short term claim is rated P1+ and a long term claim is rated A, the bank may assign 50 per cent risk weight t an unrated short term or long term claim .

Vide Sl No.9 in the Annex to DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

A debenture would meet the test of liquidity if it is traded on a recognised stock exchange(s) on at least 90 per cent of the trading days during the preceding 365 days. Further, liquidity can be evidenced in the trading during the previous one month in the recognised stock exchange if there are a minimum of 25 trades of marketable lots in securities of each issuer.

Vide Sl.No.11 in the Annex to DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008.

Vide Appendix – 2 to Annex of DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008.

Holding period will be the time normally required by the bank to realise the value of the collateral.

Table – 14: Standard Supervisory Haircuts for Sovereign and other securities which constitute Exposure and Collateral

Table – 15 : Standard Supervisory Haircut for Exposures and Collaterals which are obligations of foreign central sovereigns/foreign corporates

vii) For transactions in which the banks’ exposures are unrated or bank lends non-eligible instruments (i.e, non-investment grade corporate securities), the haircut to be applied on a exposure should be 25 per cent. (Since, at present, the repos are allowed only in the case of Government securities, the banks are not likely to have any exposure which will attract the provisions of this clause. However, this would be relevant, if in future, repos/security lending transactions are permitted in the case of unrated corporate securities).
viii) Where the collateral is a basket of assets, the haircut on the basket will be,

where ai is the weight of the asset (as measured by the amount/value of the asset in units of currency) in the basket and Hi, the haircut applicable to that asset.

ix) Adjustment for different holding periods
For some transactions, depending on the nature and frequency of the revaluation and remargining provisions, different holding periods (other than 10 business-days ) are appropriate. The framework for collateral haircuts distinguishes between repo-style transactions (i.e. repo/reverse repos and securities lending/borrowing), “other capital-market-driven transactions” (i.e. OTC derivatives transactions and margin lending) and secured lending. In capital-market-driven transactions and repo-style transactions, the documentation contains remargining clauses; in secured lending transactions, it generally does not. In view of different holding periods, in the case of these transactions, the minimum holding period shall be taken as indicated below:

The haircut for the transactions with other than 10 business-days minimum holding period, as indicated above, will have to be adjusted by scaling up/down the haircut for 10 business–days indicated in the Table-14, as per the formula given in paragraph 7.3.7 (xi) below.

x) Adjustment for non-daily mark-to-market or remargining
In case a transaction has margining frequency different from daily margining assumed, the applicable haircut for the transaction will also need to be adjusted by using the formula given in paragraph 7.3.7 (xi) below.

xi) Formula for adjustment for different holding periods and / or non-daily mark – to – market or remargining

Adjustment for the variation in holding period and margining / mark – to – market, as indicated in paragraph (ix) and (x) above will be done as per the following formula:

where:
H = haircut;
H10 = 10-business-day standard supervisory haircut for instrument
NR = actual number of business days between remargining for capital market
transactions or revaluation for secured transactions.

TM = minimum holding period for the type of transaction

7.3.8 Capital Adequacy Framework for Repo-/Reverse Repo-style transactions.

The repo-style transactions also attract capital charge for Counterparty credit risk (CCR), in addition to the credit risk and market risk. The CCR is defined as the risk of default by the counterparty in a repo-style transaction, resulting in non-delivery of the security lent/pledged/sold or non-repayment of the cash.
A. Treatment in the books of the borrower of funds
i) Where a bank has borrowed funds by selling / lending or posting, as collateral, of securities, the ‘Exposure’ will be an off-balance sheet exposure equal to the 'market value' of the securities sold/lent as scaled up after applying appropriate haircut. For the purpose, the haircut as per Table 14 would be used as the basis which should be applied by using the formula in paragraph 7.3.7 (xi), to reflect minimum (prescribed) holding period of five business-days for repo-style transactions and the variations, if any, in the frequency of re-margining, from the daily margining assumed for the standard supervisory haircut. The 'off-balance sheet exposure' will be converted into 'on-balance sheet' equivalent by applying a credit conversion factor of 100 per cent., as per item 5 in Table 8 of the circular.

ii) The amount of money received will be treated as collateral for the securities lent/sold/pledged. Since the collateral is cash, the haircut for it would be zero.

iii) The credit equivalent amount arrived at (i) above, net of amount of cash collateral, will attract a risk weight as applicable to the counterparty.

iv) As the securities will come back to the books of the borrowing bank after the repo period, it will continue to maintain the capital for the credit risk in the securities in the cases where the securities involved in repo are held under HTM category, and capital for market risk in cases where the securities are held under AFS/HFT categories. The capital charge for credit risk / specific risk would be determined according to the credit rating of the issuer of the security. In the case of Government securities, the capital charge for credit / specific risk will be 'zero'.

B. Treatment in the books of the lender of funds
i) The amount lent will be treated as on-balance sheet/funded exposure on the counter party, collateralised by the securities accepted under the repo.
ii) The exposure, being cash, will receive a zero haircut.
iii) The collateral will be adjusted downwards/marked down as per applicable haircut.
iv) The amount of exposure reduced by the adjusted amount of collateral, will receive a risk weight as applicable to the counterparty, as it is an on- balance sheet exposure.
v) The lending bank will not maintain any capital charge for the security received by it as collateral during the repo period, since such collateral does not enter its balance sheet but is only held as a bailee.

7.4 Credit risk mitigation techniques – On-balance sheet netting

On-balance sheet netting is confined to loans/advances and deposits, where banks have legally enforceable netting arrangements, involving specific lien with proof of documentation. They may calculate capital requirements on the basis of net credit exposures subject to the following conditions:

Where a bank,
a) has a well-founded legal basis for concluding that the netting or offsetting agreement is enforceable in each relevant jurisdiction regardless of whether the counterparty is insolvent or bankrupt;
b) is able at any time to determine the loans/advances and deposits with the same counterparty that are subject to the netting agreement; and
c) monitors and controls the relevant exposures on a net basis,

it may use the net exposure of loans/advances and deposits as the basis for its capital adequacy calculation in accordance with the formula in paragraph 7.3.6. Loans/advances are treated as exposure and deposits as collateral. The haircuts will be zero except when a currency mismatch exists. All the requirements contained in paragraph 7.3.6 and 7.6 will also apply.

7.5 Credit risk mitigation techniques - Guarantees

7.5.1 Where guarantees are direct, explicit, irrevocable and unconditional banks may take account of such credit protection in calculating capital requirements.
7.5.2 A range of guarantors are recognised. As under the 1988 Accord, a substitution approach will be applied. Thus only guarantees issued by entities with a lower risk weight than the counterparty will lead to reduced capital charges since the protected portion of the counterparty exposure is assigned the risk weight of the guarantor, whereas the uncovered portion retains the risk weight of the underlying counterparty.
7.5.3 Detailed operational requirements for guarantees eligible for being treated as a CRM are as under:

7.5.4 Operational requirements for guarantees

i) A guarantee (counter-guarantee) must represent a direct claim on the protection provider and must be explicitly referenced to specific exposures or a pool of exposures, so that the extent of the cover is clearly defined and incontrovertible. The guarantee must be irrevocable; there must be no clause in the contract that would allow the protection provider unilaterally to cancel the cover or that would increase the effective cost of cover as a result of deteriorating credit quality in the guaranteed exposure. The guarantee must also be unconditional; there should be no clause in the guarantee outside the direct control of the bank that could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original counterparty fails to make the payment(s) due.

ii) All exposures will be risk weighted after taking into account risk mitigation available in the form of guarantees. When a guaranteed exposure is classified as non-performing, the guarantee will cease to be a credit risk mitigant and no adjustment would be permissible on account of credit risk mitigation in the form of guarantees. The entire outstanding, net of specific provision and net of realisable value of eligible collaterals / credit risk mitigants, will attract the appropriate risk weight.

7.5.5 Additional operational requirements for guarantees

In addition to the legal certainty requirements in paragraphs 7.2 above, in order for a guarantee to be recognised, the following conditions must be satisfied:
i) On the qualifying default/non-payment of the counterparty, the bank is able in a timely manner to pursue the guarantor for any monies outstanding under the documentation governing the transaction. The guarantor may make one lump sum payment of all monies under such documentation to the bank, or the guarantor may assume the future payment obligations of the counterparty covered by the guarantee. The bank must have the right to receive any such payments from the guarantor without first having to take legal actions in order to pursue the counterparty for payment.

ii) The guarantee is an explicitly documented obligation assumed by the guarantor.

iii) Except as noted in the following sentence, the guarantee covers all types of payments the underlying obligor is expected to make under the documentation governing the transaction, for example notional amount, margin payments etc. Where a guarantee covers payment of principal only, interests and other uncovered payments should be treated as an unsecured amount in accordance with paragraph 7.5.8.

7.5.6 Range of eligible guarantors (counter-guarantors)

Credit protection given by the following entities will be recognised:
(i) Sovereigns, sovereign entities (including BIS, IMF, European Central Bank and European Community as well as those MDBs referred to in paragraph 5.5, ECGC and CGTSI), banks and primary dealers with a lower risk weight than the counterparty;
(ii) other entities rated AA (-) or better. This would include guarantee cover provided by parent, subsidiary and affiliate companies when they have a lower risk weight than the obligor. The rating of the guarantor should be an entity rating which has factored in all the liabilities and commitments (including guarantees) of the entity.

7.5.7 Risk weights

The protected portion is assigned the risk weight of the protection provider. Exposures covered by State Government guarantees will attract a risk weight of 20 per cent. The uncovered portion of the exposure is assigned the risk weight of the underlying counterparty.

7.5.8 Proportional cover

Where the amount guaranteed, or against which credit protection is held, is less than the amount of the exposure, and the secured and unsecured portions are of equal seniority, i.e. the bank and the guarantor share losses on a pro-rata basis capital relief will be afforded on a proportional basis: i.e. the protected portion of the exposure will receive the treatment applicable to eligible guarantees, with the remainder treated as unsecured.

7.5.9 Currency mismatches

Where the credit protection is denominated in a currency different from that in which the exposure is denominated – i.e. there is a currency mismatch – the amount of the exposure deemed to be protected will be reduced by the application of a haircut HFX, i.e.,
GA = G x (1- HFX)
where:
G = nominal amount of the credit protection
HFX = haircut appropriate for currency mismatch between the credit
protection and underlying obligation.
Banks using the supervisory haircuts will apply a haircut of eight per cent for currency mismatch.

7.5.10 Sovereign guarantees and counter-guarantees

A claim may be covered by a guarantee that is indirectly counter-guaranteed by a sovereign. Such a claim may be treated as covered by a sovereign guarantee provided that:
(i) the sovereign counter-guarantee covers all credit risk elements of the claim;
(ii) both the original guarantee and the counter-guarantee meet all operational requirements for guarantees, except that the counter-guarantee need not be direct and explicit to the original claim; and
(iii) the cover should be robust and no historical evidence suggests that the coverage of the counter-guarantee is less than effectively equivalent to that of a direct sovereign guarantee.

7.6 Maturity Mismatch

7.6.1 For the purposes of calculating risk-weighted assets, a maturity mismatch occurs when the residual maturity of collateral is less than that of the underlying exposure. Where there is a maturity mismatch and the CRM has an original maturity of less than one year, the CRM is not recognised for capital purposes. In other cases where there is a maturity mismatch, partial recognition is given to the CRM for regulatory capital purposes as detailed below in paragraphs 7.6.2 to 7.6.4. In case of loans collateralised by the bank’s own deposits, even if the tenor of such deposits is less than three months or deposits have maturity mismatch vis-à-vis the tenor of the loan, the provisions of paragraph 7.6.1 regarding derecognition of collateral would not be attracted provided an explicit consent of the depositor has been obtained from the depositor (i.e, borrower) for adjusting the maturity proceeds of such deposits against the outstanding loan or for renewal of such deposits till the full repayment of the underlying loan.

7.6.2 Definition of maturity

The maturity of the underlying exposure and the maturity of the collateral should both be defined conservatively. The effective maturity of the underlying should be gauged as the longest possible remaining time before the counterparty is scheduled to fulfil its obligation, taking into account any applicable grace period. For the collateral, embedded options which may reduce the term of the collateral should be taken into account so that the shortest possible effective maturity is used. The maturity relevant here is the residual maturity.

7.6.3 Risk weights for maturity mismatches

As outlined in paragraph 7.6.1, collateral with maturity mismatches are only recognised when their original maturities are greater than or equal to one year. As a result, the maturity of collateral for exposures with original maturities of less than one year must be matched to be recognised. In all cases, collateral with maturity mismatches will no longer be recognised when they have a residual maturity of three months or less.

7.6.4 When there is a maturity mismatch with recognised credit risk mitigants (collateral, on-balance sheet netting and guarantees) the following adjustment will be applied.
Pa = P x ( t- 0.25 ) ÷ ( T- 0.25)
where:
Pa = value of the credit protection adjusted for maturity mismatch
P = credit protection (e.g. collateral amount, guarantee amount) adjusted for any haircuts

t = min (T, residual maturity of the credit protection arrangement) expressed in years

T = min (5, residual maturity of the exposure) expressed in years

7.7 Treatment of pools of CRM techniques

In the case where a bank has multiple CRM techniques covering a single exposure (e.g. a bank has both collateral and guarantee partially covering an exposure), the bank will be required to subdivide the exposure into portions covered by each type of CRM technique (e.g. portion covered by collateral, portion covered by guarantee) and the risk-weighted assets of each portion must be calculated separately. When credit protection provided by a single protection provider has differing maturities, they must be subdivided into separate protection as well.

8. Capital charge for Market Risk

8.1 Introduction

Market risk is defined as the risk of losses in on-balance sheet and off-balance sheet positions arising from movements in market prices. The market risk positions subject to capital charge requirement are:
(i) The risks pertaining to interest rate related instruments and equities in the trading book; and
(ii) Foreign exchange risk (including open position in precious metals) throughout the bank (both banking and trading books).

8.2 Scope and coverage of capital charge for market risks

8.2.1 These guidelines seek to address the issues involved in computing capital charges for interest rate related instruments in the trading book, equities in the trading book and foreign exchange risk (including gold and other precious metals) in both trading and banking books. Trading book for the purpose of capital adequacy will include:
(i) Securities included under the Held for Trading category
(ii) Securities included under the Available for Sale category

(iii) Open gold position limits
(iv) Open foreign exchange position limits
(v) Trading positions in derivatives, and
(vi) Derivatives entered into for hedging trading book exposures.

8.2.2 Banks are required to manage the market risks in their books on an ongoing basis and ensure that the capital requirements for market risks are being maintained on a continuous basis, i.e. at the close of each business day. Banks are also required to maintain strict risk management systems to monitor and control intra-day exposures to market risks.
8.2.3 Capital for market risk would not be relevant for securities, which have already matured and remain unpaid. These securities will attract capital only for credit risk. On completion of 90 days delinquency, these will be treated on par with NPAs for deciding the appropriate risk weights for credit risk.

8.3 Measurement of capital charge for interest rate risk

8.3.1 This section describes the framework for measuring the risk of holding or taking positions in debt securities and other interest rate related instruments in the trading book.

8.3.2 The capital charge for interest rate related instruments would apply to current market value of these items in bank's trading book. Since banks are required to maintain capital for market risks on an ongoing basis, they are required to mark to market their trading positions on a daily basis. The current market value will be determined as per extant RBI guidelines on valuation of investments.

8.3.3 The minimum capital requirement is expressed in terms of two separately calculated charges, (i) "specific risk" charge for each security, which is designed to protect against an adverse movement in the price of an individual security owing to factors related to the individual issuer, both for short (short position is not allowed in India except in derivatives) and long positions, and (ii) "general market risk" charge towards interest rate risk in the portfolio, where long and short positions (which is not allowed in India except in derivatives) in different securities or instruments can be offset.

8.3.4 For the debt securities held under AFS category, in view of the possible longer holding period and attendant higher specific risk, the banks shall hold total capital charge for market risk equal to greater of (a) or (b) below:
a) Specific risk capital charge, computed notionally for the AFS securities treating them as held under HFT category (as computed according to Table 16: Part A/C/E, as applicable) plus the General Market Risk Capital Charge.

b) Alternative total capital charge for the AFS category computed notionally treating them as held in the banking book (as computed in accordance with table 16: Part B/D/F, as applicable)

A. Specific Risk

Vide Sl No.13 in the Annex of DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

Vide Sl No.14 in the Annex to DBOD.No.BP.BC.67/21.06.01/2007-08 dated March 31, 2008

Vide Sl No.15 in the Annex to DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

8.3.5 The capital charge for specific risk is designed to protect against an adverse movement in the price of an individual security owing to factors related to the individual issuer. The specific risk charges for various kinds of exposures would be applied as detailed below:

Table 16 – Part A

Specific Risk Capital Charge for Sovereign securities issued by
Indian and foreign sovereigns – Held by banks under the HFT Category

Table 16 – Part B

Alternative Total Capital Charge
for securities issued by Indian and foreign sovereigns

Held by banks under the AFS Category

Table 16 – Part C
Specific risk capital charge for
bonds issued by banks – Held by banks under the HFT category

Notes:
i) In the case of banks where no capital adequacy norms have been prescribed by the RBI, the lending / investing bank may calculate the CRAR of the bank concerned, notionally, by obtaining necessary information from the investee bank and using the capital adequacy norms as applicable to the commercial banks. In case, it is not found feasible to compute CRAR on such notional basis, the specific risk capital charge of 31.50 or 56.25 per cent, as per the risk perception of the investing bank, should be applied uniformly to the investing bank’s entire exposure.

ii) In case of banks where capital adequacy norms are not applicable at present, the matter of investments in their capital-eligible instruments would not arise for now. However, column Nos. 3 and 5 of the Table above will become applicable to them, if in future they issue any capital instruments where other banks are eligible to invest.

Table 16 – Part D

Alternative Total Capital Charge
for bonds issued by banks – Held by banks under AFS category
(subject to the conditions stipulated in paragraph 8.3.4)

Notes:
i) In the case of banks where no capital adequacy norms have been prescribed by the RBI, the lending / investing bank may calculate the CRAR of the bank concerned, notionally, by obtaining necessary information from the investee bank and using the capital adequacy norms as applicable to the commercial banks. In case, it is not found feasible to compute CRAR on such notional basis, the specific risk capital charge of 31.50 or 56.25 per cent, as per the risk perception of the investing bank, should be applied uniformly to the investing bank’s entire exposure.

ii) In case of banks where capital adequacy norms are not applicable at present, the matter of investments in their capital-eligible instruments would not arise for now. However, column Nos. 2 and 4 of the Table above will become applicable to them, if in future they issue any capital instruments where other banks are eligible to invest.

Table 16 – Part E

Specific Risk Capital Charge
for Corporate Bonds and Securitised Debt Instruments (SDIs)
(other than bank bonds) - Held by banks under HFT category

* These ratings indicate the ratings assigned by Indian rating agencies/ECAIs or foreign rating agencies. In the case of foreign ECAIs, the rating symbols used here correspond to Standard and Poor. The modifiers "+" or "-" have been subsumed with the main rating category.

@ In case the amount invested is less than the threshold limit prescribed in para 5.8.2, the capital charge will be 9 per cent.

Table 16 - Part F

Alternative Total Capital Charge
Corporate Bonds and Securitised Debt Instruments (SDIs)
(other than bank bonds) – Held by banks under AFS category

(subject to the conditions stipulated in para 8.3.4)

# These ratings indicate the ratings assigned by Indian rating agencies/ECAIs or foreign rating agencies. In the case of foreign ECAIs the ratings symbols used here correspond to Standard and Poor. The modifiers "+" or "-" have been subsumed with the main rating category.

8.3.6 Banks shall, in addition to computing the counterparty credit risk (CCR) charge for OTC derivatives, as part of capital for credit risk as per the Standardised Approach covered in paragraph 5 above, also compute the specific risk charge for OTC derivatives in the trading book as required in terms of Annex 8.

B. General Market Risk
8.3.7 The capital requirements for general market risk are designed to capture the risk of loss arising from changes in market interest rates. The capital charge is the sum of four components:

(i) the net short (short position is not allowed in India except in derivatives) or long position in the whole trading book;
(ii) a small proportion of the matched positions in each time-band (the “vertical disallowance”);
(iii) a larger proportion of the matched positions across different time-bands (the “horizontal disallowance”), and
(iv) a net charge for positions in options, where appropriate.

8.3.8 Separate maturity ladders should be used for each currency and capital charges should be calculated for each currency separately and then summed with no offsetting between positions of opposite sign. In the case of those currencies in which business is insignificant (where the turnover in the respective currency is less than 5 per cent of overall foreign exchange turnover), separate calculations for each currency are not required. The bank may, instead, slot within each appropriate time-band, the net long or short position for each currency. However, these individual net positions are to be summed within each time-band, irrespective of whether they are long or short positions, to produce a gross position figure. The gross positions in each time-band will be subject to the assumed change in yield set out in Table-18 with no further offsets.

8.3.9 The Basle Committee has suggested two broad methodologies for computation of capital charge for market risks. One is the standardised method and the other is the banks’ internal risk management models method. As banks in India are still in a nascent stage of developing internal risk management models, it has been decided that, to start with, banks may adopt the standardised method. Under the standardised method there are two principal methods of measuring market risk, a “maturity” method and a “duration” method. As “duration” method is a more accurate method of measuring interest rate risk, it has been decided to adopt standardised duration method to arrive at the capital charge. Accordingly, banks are required to measure the general market risk charge by calculating the price sensitivity (modified duration) of each position separately. Under this method, the mechanics are as follows:
(i) first calculate the price sensitivity (modified duration) of each instrument;

(ii) next apply the assumed change in yield to the modified duration of each instrument between 0.6 and 1.0 percentage points depending on the maturity of the instrument (see Table - 17 below);

(iii) slot the resulting capital charge measures into a maturity ladder with the fifteen time bands as set out in Table - 17;

(iv) subject long and short positions (short position is not allowed in India except in derivatives) in each time band to a 5 per cent vertical disallowance designed to capture basis risk; and

Sentence added, to ensure more clarity. The para 8.3.10 of the Circular dated April 27, 2007 has been brought here.

(v) carry forward the net positions in each time-band for horizontal offsetting subject to the disallowances set out in Table - 18.

Table 17 - Duration method – time bands and assumed changes in yield

Table 18 - Horizontal Disallowanc

8.3.10 Interest rate derivatives
The measurement of capital charge for market risks should include all interest rate derivatives and off-balance sheet instruments in the trading book and derivatives entered into for hedging trading book exposures which would react to changes in the interest rates, like FRAs, interest rate positions etc. The details of measurement of capital charge for interest rate derivatives are furnished in Annex 8.

8.4 Measurement of capital charge for equity risk

8.4.1 The capital charge for equities would apply on their current market value in bank’s trading book. Minimum capital requirement to cover the risk of holding or taking positions in equities in the trading book is set out below. This is applied to all instruments that exhibit market behaviour similar to equities but not to non-convertible preference shares (which are covered by the interest rate risk requirements described earlier). The instruments covered include equity shares, whether voting or non-voting, convertible securities that behave like equities, for example: units of mutual funds, and commitments to buy or sell equity.
Specific and general market risk

8.4.2 Capital charge for specific risk (akin to credit risk) will be 9 per cent and specific risk is computed on the banks’ gross equity positions (i.e. the sum of all long equity positions and of all short equity positions – short equity position is, however, not allowed for banks in India). The general market risk charge will also be 9 per cent on the gross equity positions.

8.5 Measurement of capital charge for foreign exchange risk

The bank’s net open position in each currency should be calculated by summing:

• The net spot position (i.e. all asset items less all liability items, including accrued interest, denominated in the currency in question);
• The net forward position (i.e. all amounts to be received less all amounts to be paid under forward foreign exchange transactions, including currency futures and the principal on currency swaps not included in the spot position);
• Guarantees (and similar instruments) that are certain to be called and are likely to be irrecoverable;
• Net future income/expenses not yet accrued but already fully hedged (at the discretion of the reporting bank);
• Depending on particular accounting conventions in different countries, any other item representing a profit or loss in foreign currencies;
• The net delta-based equivalent of the total book of foreign currency options

Foreign exchange open positions and gold open positions are at present risk-weighted at 100 per cent. Thus, capital charge for market risks in foreign exchange and gold open position is 9 per cent. These open positions, limits or actual whichever is higher, would continue to attract capital charge at 9 per cent. This capital charge is in addition to the capital charge for credit risk on the on-balance sheet and off-balance sheet items pertaining to foreign exchange and gold transactions.

8.6 Aggregation of the capital charge for market risks

Vide Sl. No.17 in the Annex to DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008.

The bullet points are added from the paragraph 718(xxii) of Basel II June 2006 document.

Proforma
(Rs. in crore)

9. Capital Charge for Operational risk

9.1 Definition of operational risk

Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk. Legal risk includes, but is not limited to, exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements.

9.2 The measurement methodologies

9.2.1 The New Capital Adequacy Framework outlines three methods for calculating operational risk capital charges in a continuum of increasing sophistication and risk sensitivity: (i) the Basic Indicator Approach (BIA); (ii) the Standardised Approach (TSA); and (iii) Advanced Measurement Approaches (AMA).
9.2.2 Banks are encouraged to move along the spectrum of available approaches as they develop more sophisticated operational risk measurement systems and practices.

9.2.3 The New Capital Adequacy Framework provides that internationally active banks and banks with significant operational risk exposures are expected to use an approach that is more sophisticated than the Basic Indicator Approach and that is appropriate for the risk profile of the institution. However, to begin with, banks in India shall compute the capital requirements for operational risk under the Basic Indicator Approach. Reserve Bank will review the capital requirement produced by the Basic Indicator Approach for general credibility, especially in relation to a bank’s peers and in the event that credibility is lacking, appropriate supervisory action under Pillar 2 will be considered.

9.3 The Basic Indicator Approach

9.3.1 Under the Basic Indicator Approach, banks must hold capital for operational risk equal to the average over the previous three years of a fixed percentage (denoted as alpha) of positive annual gross income. Figures for any year in which annual gross income is negative or zero should be excluded from both the numerator and denominator when calculating the average. If negative gross income distorts a bank’s Pillar 1 capital charge, Reserve Bank will consider appropriate supervisory action under Pillar 2. The charge may be expressed as follows:
KBIA = [ ∑ (GI1…n x α )]/n
Where:
KBIA = the capital charge under the Basic Indicator Approach
GI = annual gross income, where positive, over the previous three years
n = number of the previous three years for which gross income is positive
α = 15 per cent, which is set by the BCBS , relating the industry wide level of required capital to the industry wide level of the indicator.
9.3.2 Gross income is defined as “Net interest income” plus “net non-interest income”. It is intended that this measure should:
(i) be gross of any provisions (e.g. for unpaid interest) and write-offs made during the year;
(ii) be gross of operating expenses, including fees paid to outsourcing service providers, in addition to fees paid for services that are outsourced, fees received by banks that provide outsourcing services shall be included in the definition of gross income;
(iii) exclude reversal during the year in respect of provisions and write-offs made during the previous year(s);
(iv) exclude income recognised from the disposal of items of movable and immovable property;
(v) exclude realised profits/losses from the sale of securities in the “held to maturity” category;
(vi) exclude income from legal settlements in favour of the bank;
(vii) exclude other extraordinary or irregular items of income and expenditure; and
(viii)include income derived from insurance activities (i.e. income derived by writing insurance policies) and insurance claims in favour of the bank.

9.3.3 Banks are advised to compute capital charge for operational risk under the Basic Indicator Approach as follows:
(a) rage of [Gross Income * alpha] for each of the last three financial years, excluding years of negative or zero gross income
(b) Gross income = Net profit (+) Provisions & contingencies (+) operating expenses (Schedule 16) (–) items (iii) to (viii) of paragraph 9.3.2.
(c) Alpha = 15 per cent

9.3.4 As a point of entry for capital calculation, no specific criteria for use of the Basic Indicator Approach are set out in the New Capital Adequacy Framework. Nevertheless, banks using this approach are encouraged to comply with the Committee’s guidance on Sound Practices for the Management and Supervision of Operational Risk, February 2003 and the Guidance Note on Management of Operational Risk issued by the Reserve Bank of India in October 2005.

Part – B : Supervisory Review and Evaluation Process (SREP)

10. Introduction to the SREP under Pillar 2

10.1 The New Capital Adequacy Framework (NCAF), based on the Basel II Framework evolved by the Basel Committee on Banking Supervision, has been adapted for India vide our Circular DBOD.No.BP.BC 90/ 20.06.001/ 2006-07 dated April 27, 2007. In terms of paragraph 2.4 (iii)(c) of the Annex to the aforesaid circular the banks were required to have a Board-approved policy on ICAAP and to asses the capital requirement as per ICAAP. It is presumed that the banks would have formulated the policy and also undertaken the capital adequacy assessment accordingly.

10.2 The Basel II Framework has three components or three Pillars. The Pillar 1 is the Minimum Capital Ratio while the Pillar 2 and Pillar 3 are the Supervisory Review Process (SRP) and Market Discipline, respectively. While the guidelines on the Pillar 1 and Pillar 3 were issued by the RBI vide the aforesaid circular, since consolidated in this Master Circular in Part A and Part C, respectively, the guidelines in regard to the SRP and the Internal Capital Adequacy Assessment Process (ICAAP) are furnished at paragraph 11 below. An illustrative outline of the format of the ICAAP document, to be submitted to the RBI, by the banks, is furnished at Annex – 14.

10.3 The objective of the SRP is to ensure that the banks have adequate capital to support all the risks in their business as also to encourage them to develop and use better risk management techniques for monitoring and managing their risks. This in turn would require a well-defined internal assessment process within the banks through which they assure the RBI that adequate capital is indeed held towards the various risks to which they are exposed. The process of assurance could also involve an active dialogue between the bank and the RBI so that, when warranted, appropriate intervention could be made to either reduce the risk exposure of the bank or augment / restore its capital. Thus, ICAAP is an important component of the SRP.

10.4 The main aspects to be addressed under the SRP, and therefore, under the ICAAP, would include:
(a) the risks that are not fully captured by the minimum capital ratio prescribed
under Pillar 1;

(b) the risks that are not at all taken into account by the Pillar 1; and

(c) the factors external to the bank.
Since the capital adequacy ratio prescribed by the RBI under the Pillar 1 of the Framework is only the regulatory minimum level, addressing only the three specified risks (viz., credit, market and operational risks), holding additional capital might be necessary for the banks, on account of both – the possibility of some under-estimation of risks under the Pillar 1 and the actual risk exposure of a bank vis-à-vis the quality of its risk management architecture. Illustratively, some of the risks that the banks are generally exposed to but which are not captured or not fully captured in the regulatory CRAR would include:
(a) Interest rate risk in the banking book;
(b) Credit concentration risk;
(c) Liquidity risk;
(d) Settlement risk;
(e) Reputational risk;
(f) Strategic risk;
(g) Risk of under-estimation of credit risk under the Standardised
approach;
(h) “Model risk” i.e., the risk of under-estimation of credit risk under the IRB approaches;

(i) Risk of weakness in the credit-risk mitigants;
(j) Residual risk of securitisation, etc.
It is, therefore, only appropriate that the banks make their own assessment of their various risk exposures, through a well-defined internal process, and maintain an adequate capital cushion for such risks.

10.5 It is recognised that there is no one single approach for conducting the ICAAP and the market consensus in regard to the best practice for undertaking ICAAP is yet to emerge. The methodologies and techniques are still evolving particularly in regard to measurement of non-quantifiable risks, such as reputational and strategic risks. These guidelines, therefore, seek to provide only broad principles to be followed by the banks in developing their ICAAP.

10.6 The banks are advised to develop and put in place, with the approval of their Boards, an ICAAP commensurate with their size, level of complexity, risk profile and scope of operations. The ICAAP would be in addition to a bank’s calculation of regulatory capital requirements under Pillar 1 and must be operationalised with effect from March 31, 2008 by the foreign banks and the Indian banks with operational presence outside India, and from March 31, 2009 by all other commercial banks, excluding the Local Area Banks and Regional Rural banks.

10.7 The banks are advised to transmit to the RBI (i.e., to the CGM-in-Charge, Department of Banking Supervision, Reserve Bank of India, Central Office, Centre I, World Trade Centre, Cuffe Parade, Colaba, Mumbai – 400 005) a copy of their Board-approved ICAAP document not later than June 30, 2008 or March 31, 2009, as applicable. The document should, inter alia, include the capital adequacy assessment and projections of capital requirement for the ensuing year, along with the plans and strategies for meeting the capital requirement. An illustrative outline of a format of the ICAAP document is furnished at Annex – 14, for guidance of the banks though the ICAAP documents of the banks could vary in length and format, in tune with their size, level of complexity, risk profile and scope of operations. The first ICAAP document was required to reach the RBI not later than June 30, 2008 or March 31, 2009, as applicable, and thereafter, before the end of March every year, covering the capital assessment and projections for the following financial year.

11. Guidelines for the SREP of the RBI and the ICAAP of the banks

11.1 The Background
11.1.1 While the Basel - I framework was confined to the prescription of only minimum capital requirements for banks, the Basel II framework expands this approach not only to capture certain additional risks in the minimum capital ratio but also includes two additional areas, namely, the Supervisory Review Process and Market Discipline through increased disclosure requirements for banks. Thus, the Basel II framework rests on the following three mutually- reinforcing pillars:
Pillar 1: Minimum Capital Requirements — which prescribes a risk-sensitive calculation of capital requirements that, for the first time, explicitly includes operational risk in addition to market and credit risk.

Pillar 2: Supervisory Review Process (SRP) — which envisages the establishment of suitable risk management systems in banks and their review by the supervisory authority.

Pillar 3: Market Discipline — which seeks to achieve increased transparency through expanded disclosure requirements for banks.

11.1.2. The Basel II document of the Basel Committee also lays down the following four key principles in regard to the SRP envisaged under Pillar 2:
Principle 1 : Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.
Principle 2 : Supervisors should review and evaluate the banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with the regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.
Principle 3 : Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require the banks to hold capital in excess of the minimum.
Principle 4 : Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.
11.1.3 It would be seen that the principles 1 and 3 relate to the supervisory expectations from the banks while the principles 2 and 4 deal with the role of the supervisors under Pillar 2. The Pillar 2 (Supervisory Review Process - SRP) requires banks to implement an internal process, called the Internal Capital Adequacy Assessment Process (ICAAP), for assessing their capital adequacy in relation to their risk profiles as well as a strategy for maintaining their capital levels. The Pillar 2 also requires the supervisory authorities to subject all banks to an evaluation process, hereafter called Supervisory Review and Evaluation Process (SREP), and to initiate such supervisory measures on that basis, as might be considered necessary. An analysis of the foregoing principles indicates that the following broad responsibilities have been cast on the banks and the supervisors:

Banks’ responsibilities

(a) Banks should have in place a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels (Principle 1)

(b) Banks should operate above the minimum regulatory capital ratios (Principle3)

Supervisors’ responsibilities

(a) Supervisors should review and evaluate a bank’s ICAAP. (Principle2)
(b) Supervisors should take appropriate action if they are not satisfied with the results of this process. (Principle 2)
(c) Supervisors should review and evaluate a bank’s compliance with the regulatory capital ratios. (Principle 2)
(d) Supervisors should have the ability to require banks to hold capital in excess of the minimum. (Principle 3)
(e) Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels. (Principle 4)
(f) Supervisors should require rapid remedial action if capital is not maintained or restored. (Principle 4)

11.1.4 Thus, the ICAAP and SREP are the two important components of Pillar 2 and could be broadly defined as follows:
The ICAAP comprises a bank’s procedures and measures designed to ensure the following:
(a) An appropriate identification and measurement of risks;
(b) An appropriate level of internal capital in relation to the bank’s risk profile; and
(c) Application and further development of suitable risk management systems in the bank.

The SREP consists of a review and evaluation process adopted by the supervisor, which covers all the processes and measures defined in the principles listed above. Essentially, these include the review and evaluation of the bank’s ICAAP, conducting an independent assessment of the bank’s risk profile, and if necessary, taking appropriate prudential measures and other supervisory actions.

11.1.5 These guidelines seek to provide broad guidance to the banks by outlining the manner in which the SREP would be carried out by the RBI, the expected scope and design of their ICAAP, and the expectations of the RBI from the banks in regard to implementation of the ICAAP.

11.2 Conduct of the SREP by the RBI
11.2.1 Capital helps protect individual banks from insolvency, thereby promoting safety and soundness in the overall banking system. Minimum regulatory capital requirements under Pillar 1 establish a threshold below which a sound bank’s regulatory capital must not fall. Regulatory capital ratios permit some comparative analysis of capital adequacy across regulated banking entities because they are based on certain common methodology / assumptions. However, supervisors need to perform a more comprehensive assessment of capital adequacy that considers risks specific to a bank, conducting analyses that go beyond minimum regulatory capital requirements.

11.2.2 The RBI generally expects banks to hold capital above their minimum regulatory capital levels, commensurate with their individual risk profiles, to account for all material risks. Under the SREP, the RBI will assess the overall capital adequacy of a bank through a comprehensive evaluation that takes into account all relevant available information. In determining the extent to which banks should hold capital in excess of the regulatory minimum, the RBI would take into account the combined implications of a bank’s compliance with regulatory minimum capital requirements, the quality and results of a bank’s ICAAP, and supervisory assessment of the bank’s risk management processes, control systems and other relevant information relating to the bank’s risk profile and capital position.

11.2.3 The SREP of the banks would, thus, be conducted by the RBI periodically, generally, along with the RBI’s Annual Financial Inspection (AFI) of the banks and in the light of the data in the off-site returns received from the banks in the RBI, in conjunction with the ICAAP document, which is required to be submitted every year by the banks to the RBI (Cf. Para 11.3.4 below). Through the SREP, the RBI would evaluate the adequacy and efficacy of the ICAAP of the banks and the capital requirements derived by them therefrom. While in the course of evaluation, there would be no attempt to reconcile the difference between the regulatory minimum CRAR and the outcome of the ICAAP of a bank (as the risks covered under the two processes are different), the banks would be expected to demonstrate to the RBI that the ICAAP adopted by them is fully responsive to their size, level of complexity, scope & scale of operations and the resultant risk profile / exposures, and adequately captures their capital requirements. Such an evaluation of the effectiveness of the ICAAP would help the RBI in understanding the capital management processes and strategies adopted by the banks. If considered necessary, the SREP could also involve a dialogue between the bank’s top management and the RBI from time to time. In addition to the periodic reviews, independent external experts may also be commissioned by the RBI, if deemed necessary, to perform ad hoc reviews and comment on specific aspects of the ICAAP process of a bank; the nature and extent of such a review shall be determined by the RBI.

11.2.4 Under the SREP, the RBI would also seek to determine whether a bank’s overall capital remains adequate as the underlying conditions change. Generally, material increases in risk that are not otherwise mitigated should be accompanied by commensurate increases in capital. Conversely, reductions in overall capital (to a level still above regulatory minima) may be appropriate if the RBI’s supervisory assessment leads it to a conclusion that risk has materially declined or that it has been appropriately mitigated. Based on such an assessment, the RBI could consider initiating appropriate supervisory measures to address its supervisory concerns. The measures could include requiring a modification or enhancement of the risk management and internal control processes of a bank, a reduction in risk exposures, or any other action as deemed necessary to address the identified supervisory concerns. These measures could also include the stipulation of a bank-specific minimum CRAR that could potentially be even higher, if so warranted by the facts and circumstances, than the regulatory minimum stipulated under the Pillar 1. In cases where the RBI decides to stipulate a CRAR at a level higher than the regulatory minimum, it would explain the rationale for doing so, to the bank concerned. However, such an add-on CRAR stipulation, though possible, is not expected to be an automatic or inevitable outcome of the SREP exercise, the prime objective being improvement in the risk management systems of the banks.

11.2.5 As and when the advanced approaches envisaged in the Basel II document are permitted to be adopted in India, the SREP would also assess the ongoing compliance by the banks with the eligibility criteria for adopting the advanced approaches.

11.3 The structural aspects of the ICAAP
11.3.1 This section outlines the broad parameters of the ICAAP that the banks are required to comply with in designing and implementing their ICAAP.

11.3.2 Every bank to have an ICAAP
Reckoning that the Basel II framework is applicable to all commercial banks (except the Local Area Banks and the Regional Rural Banks), both at the solo level (global position) as well as at the consolidated level, the ICAAP should be prepared, on a solo basis, at every tier for each banking entity within the banking group, as also at the level of the consolidated bank (i.e., a group of entities where the licensed bank is the controlling entity). This requirement would also apply to the foreign banks which have a branch presence in India and their ICAAP should cover their Indian operations only.

11.3.3 ICAAP to be a Board-approved process

The ultimate responsibility for designing and implementation of the ICAAP lies with the bank’s board of directors of the bank and with the Chief Executive Officer in the case of the foreign banks with branch presence in India. The structure, design and contents of a bank’s ICAAP should be approved by the board of directors to ensure that the ICAAP forms an integral part of the management process and decision making culture of the bank. Since a sound risk management process provides the basis for ensuring that a bank maintains adequate capital, the board of directors of a bank shall:

(a) set the tolerance level for risk;
(b) ensure that the senior management of the bank:
i establishes a risk framework in order to assess and appropriately manage the various risk exposures of the bank;
ii develops a system to monitor the bank’s risk exposures and to relate them to the bank’s capital and reserve funds;
iii establishes a method to monitor the bank’s compliance with internal policies, particularly in regard to risk management;
iv effectively communicates all relevant policies and procedures throughout the bank;

c) adopt and support strong internal controls;
d) ensure that the bank has appropriate written policies and procedures in place;
e) ensure that the bank has an appropriate strategic plan in place, which, as a minimum, shall duly outline
f) the bank’s current and future capital needs;
g) the bank’s anticipated capital expenditure; and
h) the bank’s desired level of capital.

11.3.4 Submission of the outcome of the ICAAP to the Board and the RBI

As the ICAAP is an ongoing process, a written record on the outcome of the ICAAP should to be periodically submitted by the banks to their board of directors. Such written record of the internal assessment of its capital adequacy should include, inter alia, the risks identified, the manner in which those risks are monitored and managed, the impact of the bank’s changing risk profile on the bank’s capital position, details of stress tests/scenario analysis conducted and the resultant capital requirements. The reports shall be sufficiently detailed to allow the Board of Directors to evaluate the level and trend of material risk exposures, whether the bank maintains adequate capital against the risk exposures and in case of additional capital being needed, the plan for augmenting capital. The board of directors would be expected make timely adjustments to the strategic plan, as necessary.

Based on the outcome of the ICAAP as submitted to and approved by the Board, the ICAAP Document, in the format furnished at Annex 14, should be furnished to the RBI (i.e., to the CGM-in-Charge, Department of Banking Supervision, Central Office, Reserve Bank of India, World Trade Centre, Centre I, Colaba, Cuffe Parade, Mumbai – 400 005). To begin with, the Document, duly approved by the Board, should be sent to the RBI only once a year, for the year ending March 31, but the frequency of submission could be reviewed in due course. The first such submission was required to be for the year ending March 31, 2008 by the banks which migrated to Basel II framework from that date while the remaining banks would submit their first ICAAP Document for the year ending March 31, 2009, the date from which they would switch over to the Basel II framework. The document should reach the RBI latest by June 30, 2008 in respect of the first set of banks and by March 31, 2009 in respect of the second set of banks, and thereafter, by end of March every year.

11.3.5 Review of the ICAAP outcomes

The board of directors shall, at least once a year, assess and document whether the processes relating the ICAAP implemented by the bank successfully achieve the objectives envisaged by the board. The senior management should also receive and review the reports regularly to evaluate the sensitivity of the key assumptions and to assess the validity of the bank’s estimated future capital requirements. In the light of such an assessment, appropriate changes in the ICAAP should be instituted to ensure that the underlying objectives are effectively achieved.

11.3.6 ICAAP to be an Integral part of the management and decision-making culture

The ICAAP should from an integral part of the management and decision-making culture of a bank. This integration could range from using the ICAAP to internally allocate capital to various business units, to having it play a role in the individual credit decision process and pricing of products or more general business decisions such as expansion plans and budgets. The integration would also mean that ICAAP should enable the bank management to assess, on an ongoing basis, the risks that are inherent in their activities and material to the institution.

11.3.7 The Principle of proportionality

The implementation of ICAAP should be guided by the principle of proportionality. Though the banks are encouraged to migrate to and adopt progressively sophisticated approaches in designing their ICAAP, the RBI would expect the degree of sophistication adopted in the ICAAP in regard to risk measurement and management to be commensurate with the nature, scope, scale and the degree of complexity in the bank’s business operations. The following paragraphs illustratively enumerate the broad approach which could be considered by the banks with varying levels of complexity in their operations, in formulating their ICAAP.

(A) In relation to a bank that defines its activities and risk management practices as simple, in carrying out its ICAAP, that bank could:

(a) identify and consider that bank’slargest losses over the last 3 to 5 years and whether those losses are likely to recur;

(b) prepare a short list of the most significant risks to which that bank is exposed;

(c) consider how that bankwould act, and the amount of capital that would be absorbed in the event that each of the risks identified were to materialise;

(d) consider how that bank’scapital requirementmight alter under the scenarios in (c) and how its capital requirementmight alter in line with its business plans for the next 3 to 5 years; and

(e) document the ranges of capital required in the scenarios identified above and form an overall view on the amount and quality of capital which that bankshould hold, ensuring that its senior management is involved in arriving at that view.

(B) In relation to a bank that define its activities and risk management practices as moderately complex, in carrying out its ICAAP, that bank could:

(a) having consulted the operational management in each major business line, prepare a comprehensive list of the major risks to which the business is exposed;
(b) estimate, with the aid of historical data, where available, the range and distribution of possible losses which might arise from each of those risks and consider using shock stress tests to provide risk estimates;
(c) consider the extent to which that bank’s capital requirementadequately captures the risks identified in (a) and (b) above;
(d) for areas in which the capital requirementis either inadequate or does not address a risk, estimate the additional capital needed to protect that bank and its customers, in addition to any other risk mitigation action that bankplans to take;
(e) consider the risk that the bank’sown analyses of capital adequacy may be inaccurate and that it may suffer from management weaknesses which affect the effectiveness of its risk management and mitigation;
(f) project that bank’sbusiness activities forward in detail for one year and in less detail for the next 3 to 5 years, and estimate how that bank’s capital and capital requirementwould alter, assuming that business develops as expected;
(g) assume that business does not develop as expected and consider how thatbank’s capital and capital requirementwould alter and what that bank’sreaction to a range of adverse economic scenarios might be;
(h) document the results obtained from the analyses in (b), (d), (f), and (g) above in a detailed report for that bank’stop management / board of directors; and
(i) ensure that systems and processes are in place to review the accuracy of the estimates made in (b), (d), (f) and (g) (i.e., systems for back testing) vis-à-vis the performance / actuals.

(C) In relation to a bank that define its activities and risk management practices as complex, in carrying out its ICAAP, that bank could follow a proportional approach to that bank’s ICAAPwhich should cover the issues identified at (a) to (d) in paragraph (B) above, but is likely also to involve the use of models, most of which will be integrated into its day-to-day management and operations.

Models of the kind referred to above may be linked so as to generate an overall estimate of the amount of capital that a bankconsiders appropriate to hold for its business needs. A bankmay also link such models to generate information on the economic capital considered desirable for that bank. A model which a bankuses to generate its target amount of economic capital is known as an economic capital model (ECM). Economic capital is the target amount of capital which optimises the return for a bank’sstakeholders for a desired level of risk. For example, a bankis likely to use value-at-risk (VaR) models formarket risk, advanced modelling approaches for credit risk and, possibly, advanced measurement approaches for operational risk. A bankmight also use economic scenario generators to model stochastically its business forecasts and risks. However, the advanced approaches envisaged in the Basel II Framework are not currently permitted by the RBI and the banks would need prior approval of the RBI for migrating to the advanced approaches.

Such a bank is also likely to be part of a groupand to be operating internationally. There is likely to be centralised control over the models used throughout thegroup, the assumptions made and their overall calibration.

11.3.8 Regular independent review and validation

The ICAAP should be subject to regular and independent review through an internal or external audit process, separately from the SREP conducted by the RBI, to ensure that the ICAAP is comprehensive and proportionate to the nature, scope, scale and level of complexity of the bank’s activities so that it accurately reflects the major sources of risk that the bank is exposed to. A bank shall ensure appropriate and effective internal control structures, particularly in regard to the risk management processes, in order to monitor the bank’s continued compliance with internal policies and procedures. As a minimum, a bank shall conduct periodic reviews of its risk management processes, which should ensure:

(a) the integrity, accuracy, and reasonableness of the processes;
(b) the appropriateness of the bank’s capital assessment process based on the nature, scope, scale and complexity of the bank’s activities;
(c) the timely identification of any concentration risk;
(d) the accuracy and completeness of any data inputs into the bank’s capital assessment process;
(e) the reasonableness and validity of any assumptions and scenarios used in the capital assessment process;
(f) that the bank conducts appropriate stress testing;

11.3.9 ICAAP to be a forward-looking process

The ICAAP should be forward looking in nature, and thus, should take into account the expected / estimated future developments such as strategic plans, macro economic factors, etc., including the likely future constraints in the availability and use of capital. As a minimum, the management of a bank shall develop and maintain an appropriate strategy that would ensure that the bank maintains adequate capital commensurate with the nature, scope, scale, complexity and risks inherent in the bank’s on-balance-sheet and off-balance-sheet activities, and should demonstrate as to how the strategy dovetails with the macro-economic factors.

Thus, the banks shall have an explicit, Board-approved capital plan which should spell out the institution's objectives in regard to level of capital, the time horizon for achieving those objectives, and in broad terms, the capital planning process and the allocate responsibilities for that process. The plan shall outline:

(a) the bank’s capital needs;
(b) the bank’s anticipated capital utilisation;
(c) the bank’s desired level of capital;
(d) limits related to capital;
(e) a general contingency plan for dealing with divergences and unexpected events.

11.3.10 ICAAP to be a risk-based process

The adequacy of a bank’s capital is a function of its risk profile. Banks shall, therefore, set their capital targets which are consistent with their risk profile and operating environment. As a minimum, a bank shall have in place a sound ICAAP, which shall include all material risk exposures incurred by the bank. There are some types of risks (such as reputation risk and strategic risk) which are less readily quantifiable; for such risks, the focus of the ICAAP should be more on qualitative assessment, risk management and mitigation than on quantification of such risks. Banks’ ICAAP document shall clearly indicate for which risks a quantitative measure is considered warranted, and for which risks a qualitative measure is considered to be the correct approach.

11.3.11 ICAAP to include stress tests and scenario analyses

As part of the ICAAP, the management of a bank shall, as a minimum, conduct relevant stress tests periodically, particularly in respect of the bank’s material risk exposures, in order to evaluate the potential vulnerability of the bank to some unlikely but plausible events or movements in the market conditions that could have an adverse impact on the bank. The use of stress testing framework can provide a bank’s management a better understanding of the bank’slikely exposure in extreme circumstances. In this context, the attention is also invited to the RBI circular DBOD.No.BP.BC.101/21.04.103/2006-07 dated June 26, 2007 on stress testing wherein the banks were advised to put in place appropriate stress testing policies and stress test frameworks, incorporating “sensitivity tests” and “scenario tests”, for the various risk factors, by September 30, 2007, on a trial / pilot basis and to operationalise formal stress testing frameworks from March 31, 2008. The banks are urged to take necessary measures for implementing an appropriate formal stress testing framework by the date specified which would also meet the stress testing requirements under the ICAAP of the banks.

11.3.12 Use of capital models for ICAAP

While the RBI does not expect the banks to use complex and sophisticated econometric models for internal assessment of their capital requirements, and there is no RBI-mandated requirement for adopting such models, the banks, with international presence, were required, in terms of paragraph 17 of our Circular DBOD.No.BP(SC).BC98/21.04.103/99 dated October 7, 1999, to develop suitable methodologies, by March 31, 2001, for estimating and maintaining economic capital. However, some of the banks which have relatively complex operations and are adequately equipped in this regard, may like to place reliance on such models as part of their ICAAP. While there is no single prescribed approach as to how a bank should develop its capital model, a bank adopting a model-based approach to its ICAAP shall be able to, inter alia, demonstrate:

(a) l documented model specifications, including the methodology / mechanics and the assumptions underpinning the working of the model;
(b) The extent of reliance on the historical data in the model and the system of back testing to be carried out to assess the validity of the outputs of the model vis-à-vis the actual outcomes;
(c) A robust system for independent validation of the model inputs and outputs;
(d) A system of stress testing the model to establish that the model remains valid even under extreme conditions / assumptions;
(e) The level of confidence assigned to the model outputs and its linkage to the bank’s business strategy;
(f) The adequacy of the requisite skills and resources within the banks to operate, maintain and develop the model.

11.4 Select operational aspects of the ICAAP
This Section outlines in somewhat greater detail the scope of the risk universe expected to be normally captured by the banks in their ICAAP.

11.4.1 Identifying and measuring material risks in ICAAP
The first objective of an ICAAP is to identify all material risks. Risks that can be reliably measured and quantified should be treated as rigorously as data and methods allow. The appropriate means and methods to measure and quantify those material risks are likely to vary across banks.

Some of the risks to which banks are exposed include credit risk, market risk, operational risk, interest rate risk in the banking book, credit concentration risk and liquidity risk (as briefly outlined below). The RBI has issued guidelines to the banks on asset liability management, management of country risk, credit risk, operational risk, etc., from time to time. A bank’s risk management processes, including its ICAAP, should, therefore, be consistent with this existing body of guidance. However, certain other risks, such as reputational risk and business or strategic risk, may be equally important for a bank and, in such cases, should be given same consideration as the more formally defined risk types. For example, a bank may be engaged in businesses for which periodic fluctuations in activity levels, combined with relatively high fixed costs, have the potential to create unanticipated losses that must be supported by adequate capital. Additionally, a bank might be involved in strategic activities (such as expanding business lines or engaging in acquisitions) that introduce significant elements of risk and for which additional capital would be appropriate.

Additionally, if banks employ risk mitigation techniques, they should understand the risk to be mitigated and the potential effects of that mitigation, reckoning its enforceability and effectiveness, on the risk profile of the bank.

11.4.2 Credit risk : A bank should have the ability to assess credit risk at the portfolio level as well as at the exposure or counterparty level. Banks should be particularly attentive to identifying credit risk concentrations and ensuring that their effects are adequately assessed. This should include consideration of various types of dependence among exposures, incorporating the credit risk effects of extreme outcomes, stress events, and shocks to the assumptions made about the portfolio and exposure behavior. Banks should also carefully assess concentrations in counterparty credit exposures, including counterparty credit risk exposures emanating from trading in less liquid markets, and determine the effect that these might have on the bank’s capital adequacy.

11.4.3 Market risk: A bank should be able to identify risks in trading activities resulting from a movement in market prices. This determination should consider factors such as illiquidity of instruments, concentrated positions, one-way markets, non-linear/deep out-of-the money positions, and the potential for significant shifts in correlations. Exercises that incorporate extreme events and shocks should also be tailored to capture key portfolio vulnerabilities to the relevant market developments.

11.4.4 Operational risk: A bank should be able to assess the potential risks resulting from inadequate or failed internal processes, people, and systems, as well as from events external to the bank. This assessment should include the effects of extreme events and shocks relating to operational risk. Events could include a sudden increase in failed processes across business units or a significant incidence of failed internal controls.

11.4.5 Interest rate risk in the banking book (IRRBB): A bank should identify the risks associated with the changing interest rates on its on-balance sheet and off-balance sheet exposures in the banking book from both, a short-term and long-term perspective. This might include the impact of changes due to parallel shocks, yield curve twists, yield curve inversions, changes in the relationships of rates (basis risk), and other relevant scenarios. The bank should be able to support its assumptions about the behavioral characteristics of its non-maturity deposits and other assets and liabilities, especially those exposures characterised by embedded optionality. Given the uncertainty in such assumptions, stress testing and scenario analysis should be used in the analysis of interest rate risks. While there could be several approaches to measurement of IRRBB, an illustrative approach for measurement of IRRBB is furnished at Annex 9. The banks would, however, be free to adopt any other variant of these approaches or entirely different methodology for computing / quantifying the IRRBB provided the technique is based on objective, verifiable and transparent methodology and criteria.

11.4.6 Credit concentration risk: A risk concentration is any single exposure or a group of exposures with the potential to produce losses large enough (relative to a bank’s capital, total assets, or overall risk level) to threaten a bank’s health or ability to maintain its core operations. Risk concentrations have arguably been the single most important cause of major problems in banks. Concentration risk resulting from concentrated portfolios could be significant for most of the banks.

The following qualitative criteria could be adopted by the banks to demonstrate that the credit concentration risk is being adequately addressed:

a) While assessing the exposure to concentration risk, a bank should keep in view that the calculations of Basel II framework are based on the assumption that a bank is well diversified.

b) While the banks’ single borrower exposures, the group borrower exposures and capital market exposures are regulated by the exposure norms prescribed by the RBI, there could be concentrations in these portfolios as well. In assessing the degree of credit concentration, therefore, a bank shall consider not only the foregoing exposures but also consider the degree of credit concentration in a particular economic sector or geographical area. The banks with operational concentration in a few geographical regions, by virtue of the pattern of their branch network, shall also consider the impact of adverse economic developments in that region, and their impact on the asset quality.

c) The performance of specialised portfolios may, in some instances, also depend on key individuals / employees of the bank. Such a situation could exacerbate the concentration risk because the skills of those individuals, in part, limit the risk arising from a concentrated portfolio. The impact of such key employees / individuals on the concentration risk is likely to be correspondingly greater in smaller banks. In developing its stress tests and scenario analyses, a bankshall, therefore, also consider the impact of losing key personnel on its ability to operate normally, as well as the direct impact on its revenues.

As regards the quantitative criteria to be used to ensure that credit concentration risk is being adequately addressed, the credit concentration risk calculations shall be performed at the counterparty level (i.e., large exposures), at the portfolio level (i.e., sectoral and geographical concentrations) and at the asset class level (i.e., liability and assets concentrations). In this regard, a reference is invited to paragraph 3.2.2 (c) of the Annex to our Circular DBOD.No.BP.(SC).BC.98/ 21.04.103/ 99dated October 7, 1999 regarding Risk Management System in Banks in terms of which certain prudential limits have been stipulated in regard to ‘substantial exposures’ of banks. As a prudent practice, the banks may like to ensure that their aggregate exposure (including non-funded exposures) to all ‘large borrowers’ does not exceed at any time, 800 per cent of their ‘capital funds’ (as defined for the purpose of extant exposure norms of the RBI). The ‘large borrower’ for this purpose could be taken to mean as one to whom the bank’s aggregate exposure (funded as well as non-funded) exceeds 10 per cent of the bank’s capital funds. The banks would also be well advised to pay special attention to their industry-wise exposures where their exposure to a particular industry exceeds 10 per cent of their aggregate credit exposure (including investment exposure) to the industrial sector as a whole.

There could be several approaches to the measurement of credit concentration the banks’ portfolio. One of the approaches commonly used for the purpose involves computation of Herfindahl-Hirshman Index (HHI). It may please be noted that the HHI as a measure of concentration risk is only one of the possible methods and the banks would be free to adopt any other appropriate method for the purpose, which has objective and transparent criteria for such measurement.

11.4.7 Liquidity risk: A bank should understand the risks resulting from its inability to meet its obligations as they come due, because of difficulty in liquidating assets (market liquidity risk) or in obtaining adequate funding (funding liquidity risk). This assessment should include analysis of sources and uses of funds, an understanding of the funding markets in which the bank operates, and an assessment of the efficacy of a contingency funding plan for events that could arise.

11.4.8 The risk factors discussed above should not be considered an exhaustive list of those affecting any given bank. All relevant factors that present a material source of risk to capital should be incorporated in a well-developed ICAAP. Furthermore, banks should be mindful of the capital adequacy effects of concentrations that may arise within each risk type.

11.4.9 Quantitative and qualitative approaches in ICAAP

(a) All measurements of risk incorporate both quantitative and qualitative elements, but to the extent possible, a quantitative approach should form the foundation of a bank’s measurement framework. In some cases, quantitative tools can include the use of large historical databases; when data are more scarce, a bank may choose to rely more heavily on the use of stress testing and scenario analyses. Banks should understand when measuring risks that measurement error always exists, and in many cases the error is itself difficult to quantify. In general, an increase in uncertainty related to modeling and business complexity should result in a larger capital cushion.

(b) Quantitative approaches that focus on most likely outcomes for budgeting, forecasting, or performance measurement purposes may not be fully applicable for capital adequacy because the ICAAP should also take less likely events into account. Stress testing and scenario analysis can be effective in gauging the consequences of outcomes that are unlikely but would have a considerable impact on safety and soundness.

(c) To the extent that risks cannot be reliably measured with quantitative tools – for example, where measurements of risk are based on scarce data or unproven quantitative methods – qualitative tools, including experience and judgment, may be more heavily utilised. Banks should be cognisant that qualitative approaches have their own inherent biases and assumptions that affect risk assessment; accordingly, banks should recognise the biases and assumptions embedded in, and the limitations of, the qualitative approaches used.
11.4.10 Risk aggregation and diversification effects
(a) An effective ICAAP should assess the risks across the entire bank. A bank choosing to conduct risk aggregation among various risk types or business lines should understand the challenges in such aggregation. In addition, when aggregating risks, banks should be ensure that any potential concentrations across more than one risk dimension are addressed, recognising that losses could arise in several risk dimensions at the same time, stemming from the same event or a common set of factors. For example, a localised natural disaster could generate losses from credit, market, and operational risks at the same time.

(b) In considering the possible effects of diversification, management should be systematic and rigorous in documenting decisions, and in identifying assumptions used in each level of risk aggregation. Assumptions about diversification should be supported by analysis and evidence. The bank should have systems capable of aggregating risks based on the bank’s selected framework. For example, a bank calculating correlations within or among risk types should consider data quality and consistency, and the volatility of correlations over time and under stressed market conditions.

Part – C : Market Discipline

12. Guidelines for Market Discipline

12.1 General

12.1.1 The purpose of Market discipline (detailed in Pillar 3) in the Revised Framework is to complement the minimum capital requirements (detailed under Pillar 1) and the supervisory review process (detailed under Pillar 2). The aim is to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution.

12.1.2 In principle, banks’ disclosures should be consistent with how senior management and the Board of directors assess and manage the risks of the bank. Under Pillar 1, banks use specified approaches/ methodologies for measuring the various risks they face and the resulting capital requirements. It is believed that providing disclosures that are based on a common framework is an effective means of informing the market about a bank’s exposure to those risks and provides a consistent and comprehensive disclosure framework that enhances comparability

12.2 Achieving appropriate disclosure

12.2.1 Market discipline can contribute to a safe and sound banking environment. Hence, non-compliance with the prescribed disclosure requirements would attract a penalty, including financial penalty. However, it is not intended that direct additional capital requirements would be a response to non-disclosure, except as indicated below.

12.2.2 In addition to the general intervention measures, the Revised Framework also anticipates a role for specific measures. Where disclosure is a qualifying criterion under Pillar 1 to obtain lower risk weightings and/or to apply specific methodologies, there would be a direct sanction (not being allowed to apply the lower risk weighting or the specific methodology).

12.3 Interaction with accounting disclosures

It is recognised that the Pillar 3 disclosure framework does not conflict with requirements under accounting standards, which are broader in scope. The BCBS has taken considerable efforts to see that the narrower focus of Pillar 3, which is aimed at disclosure of bank capital adequacy, does not conflict with the broader accounting requirements. The Reserve Bank will consider future modifications to the Market Discipline disclosures as necessary in light of its ongoing monitoring of this area and industry developments.

12.4 Scope and frequency of disclosures

12.4.1 Banks, including consolidated banks, should provide all Pillar 3 disclosures, both qualitative and quantitative, as at end March each year along with the annual financial statements. With a view to enhance the ease of access to the Pillar 3 disclosures, banks may make their annual disclosures both in their annual reports as well as their respective web sites. Banks with capital funds of Rs.100 crore or more should make interim disclosures on the quantitative aspects, on a stand alone basis, on their respective websites as at end September each year. Qualitative disclosures that provide a general summary of a bank’s risk management objectives and policies, reporting system and definitions may be published only on an annual basis.

12.4.2 In recognition of the increased risk sensitivity of the Revised Framework and the general trend towards more frequent reporting in capital markets, all banks with capital funds of Rs. 500 crore or more, and their significant bank subsidiaries, must disclose their Tier 1 capital, total capital, total required capital and Tier 1 ratio and total capital adequacy ratio, on a quarterly basis on their respective websites.

12.4.3 The disclosure on the websites should be made in a web page titled “Basel II Disclosures” and the link to this page should be prominently provided on the home page of the bank’s website. Each of these disclosures pertaining to a financial year should be available on the websites until disclosure of the third subsequent annual (March end) disclosure is made.

12.5 Validation

The disclosures in this manner should be subjected to adequate validation. For example, since information in the annual financial statements would generally be audited, the additional material published with such statements must be consistent with the audited statements. In addition, supplementary material (such as Management’s Discussion and Analysis) that is published should also be subjected to sufficient scrutiny (e.g. internal control assessments, etc.) to satisfy the validation issue. If material is not published under a validation regime, for instance in a stand alone report or as a section on a website, then management should ensure that appropriate verification of the information takes place, in accordance with the general disclosure principle set out below. In the light of the above, Pillar 3 disclosures will not be required to be audited by an external auditor, unless specified.

12.6 Materiality

A bank should decide which disclosures are relevant for it based on the materiality concept. Information would be regarded as material if its omission or misstatement could change or influence the assessment or decision of a user relying on that information for the purpose of making economic decisions. This definition is consistent with International Accounting Standards and with the national accounting framework. The Reserve Bank recognises the need for a qualitative judgment of whether, in light of the particular circumstances, a user of financial information would consider the item to be material (user test). The Reserve Bank does not consider it necessary to set specific thresholds for disclosure as the user test is a useful benchmark for achieving sufficient disclosure. However, with a view to facilitate smooth transition to greater disclosures as well as to promote greater comparability among the banks’ Pillar 3 disclosures, the materiality thresholds have been prescribed for certain limited disclosures. Notwithstanding the above, banks are encouraged to apply the user test to these specific disclosures and where considered necessary make disclosures below the specified thresholds also.

12.7 Proprietary and confidential information

Proprietary information encompasses information (for example on products or systems), that if shared with competitors would render a bank’s investment in these products/systems less valuable, and hence would undermine its competitive position. Information about customers is often confidential, in that it is provided under the terms of a legal agreement or counterparty relationship. This has an impact on what banks should reveal in terms of information about their customer base, as well as details on their internal arrangements, for instance methodologies used, parameter estimates, data etc. The Reserve Bank believes that the requirements set out below strike an appropriate balance between the need for meaningful disclosure and the protection of proprietary and confidential information.

12.8 General disclosure principle

Banks should have a formal disclosure policy approved by the Board of directors that addresses the bank’s approach for determining what disclosures it will make and the internal controls over the disclosure process. In addition, banks should implement a process for assessing the appropriateness of their disclosures, including validation and frequency.

12.9 Scope of application

Pillar 3 applies at the top consolidated level of the banking group to which the Framework applies (as indicated above under paragraph 3 Scope of Application). Disclosures related to individual banks within the groups would not generally be required to be made by the parent bank. An exception to this arises in the disclosure of Total and Tier 1 Capital Ratios by the top consolidated entity where an analysis of significant bank subsidiaries within the group is appropriate, in order to recognise the need for these subsidiaries to comply with the Framework and other applicable limitations on the transfer of funds or capital within the group. Pillar 3 disclosures will be required to be made by the individual banks on a standalone basis when they are not the top consolidated entity in the banking group.

12.10 Effective date of disclosures

The first of the disclosures as per these guidelines shall be made as on the effective date viz. March 31, 2008 or 2009, as the case may be. Banks are, however, encouraged to make the Pillar 3 disclosures at an earlier date.

12.11 The disclosure requirements

The following sections set out in tabular form are the disclosure requirements under Pillar 3. Additional definitions and explanations are provided in a series of footnotes.

Table DF – 1 : Scope of Application

For example: Disclosures for the financial year ending March 31, 2009 (i.e., June/ September/ December 2008 and March 2009) should be available until disclosure as on March 31, 2012.

Entity = securities, insurance and other financial subsidiaries, commercial subsidiaries, significant minority equity investments in insurance, financial and commercial entities.

viz. subsidiaries as in consolidated accounting, e.g. AS 21.

viz. Joint ventures in consolidated accounting, e.g. AS 27.

A capital deficiency is the amount by which actual capital is less than the regulatory capital requirement. Any deficiencies which have been deducted on a group level in addition to the investment in such subsidiaries are not to be included in the aggregate capital deficiency.

Table DF – 2 : Capital Structure

Table DF – 3 : Capital Adequacy

12.12 Risk exposure and assessment
The risks to which banks are exposed and the techniques that banks use to identify, measure, monitor and control those risks are important factors market participants consider in their assessment of an institution. In this section, several key banking risks are considered: credit risk, market risk, and interest rate risk in the banking book and operational risk. Also included in this section are disclosures relating to credit risk mitigation and asset securitisation, both of which alter the risk profile of the institution. Where applicable, separate disclosures are set out for banks using different approaches to the assessment of regulatory capital.

12.13 General qualitative disclosure requirement
For each separate risk area (e.g. credit, market, operational, banking book interest rate risk) banks must describe their risk management objectives and policies, including:
(i) strategies and processes;
(ii) the structure and organisation of the relevant risk management function;
(iii) the scope and nature of risk reporting and/or measurement systems;
(iv) policies for hedging and/or mitigating risk and strategies and processes for monitoring the continuing effectiveness of hedges/mitigants.

Credit risk
General disclosures of credit risk provide market participants with a range of information about overall credit exposure and need not necessarily be based on information prepared for regulatory purposes. Disclosures on the capital assessment techniques give information on the specific nature of the exposures, the means of capital assessment and data to assess the reliability of the information disclosed.

Table DF – 4 :Credit Risk : General Disclosures for All Banks

That is after accounting offsets in accordance with the applicable accounting regime and without taking into account the effects of credit risk mitigation techniques, e.g. collateral and netting.

That is, on the same basis as adopted for Segment Reporting adopted for compliance with AS 17.

The industries break-up may be provided on the same lines as prescribed for DSB returns. If the exposure to any particular industry is more than 5 per cent of the gross credit exposure as computed under (b) above it should be disclosed separately.

Banks shall use the same maturity bands as used for reporting positions in the ALM returns.

Table DF – 5

Credit Risk: Disclosures for Portfolios Subject to the Standardised Approach

Table DF – 6

Credit Risk Mitigation: Disclosures for Standardised Approaches

As defined for disclosures in Table 4

At a minimum, banks must give the disclosures in this Table in relation to credit risk mitigation that has been recognised for the purposes of reducing capital requirements under this Framework. Where relevant, banks are encouraged to give further information about mitigants that have not been recognised for that purpose.

As defined for disclosures in Table DF-4 after application of haircuts for exposure

Table DF – 7 :Securitisation : Disclosure for Standardised Approach

Table DF- 8 : Market Risk in Trading Book

For example: originator, investor, and servicer, provider of credit enhancement, liquidity provider, and swap provider.

For example, credit cards, home equity, auto, etc.

Securitisation transactions in which the originating bank does not retain any securitisation exposure should be shown separately but need only be reported for the year of inception.

Where relevant, banks are encouraged to differentiate between exposures resulting from activities in which they act only as sponsors, and exposures that result from all other bank securitisation activities that are subject to the securitisation framework.

For example, write-offs/provisions (if the assets remain on the bank’s balance sheet) or write-downs of I/O strips and other residual interests.

Securitisation exposures, include, but are not restricted to, securities, liquidity facilities, other commitments and credit enhancements such as I/O strips, cash collateral accounts and other subordinated assets.

Table DF-9 :Operational Risk

Table DF- 10 : Interest Rate Risk in the Banking Book (IRRBB)

^1. The need for continuing with the prudential floor will be reviewed periodically by the Reserve Bank.

^2. Total Tier 1 capital funds, subject to prudential limits for Innovative Perpetual Debt Instruments minus deductions from Tier 1 capital

^3. Total of eligible Tier 1 capital funds and eligible Tier 2 capital funds, subject to prudential limits for Innovative Tier 1 instruments, Upper Tier 2 instruments and subordinated debt instruments minus deductions from Tier 1 and Tier 2 capital

^4. Floating Provisions held by banks, which is general in nature and not made against any identified assets may be treated as part of Tier 2, if such provisions are not netted off from GNPAs to arrive at disclosure of net NPAs.

^5. Vide Sl No.1 of Annex to circular DBOD.BP.BC.No.67/21.06.001/2007-08 dated March 31, 2008

^6. Vide Sl. No.2 in Annex to circular DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

^7. Vide paragraph 2.2 of  circular DBOD.No.BP.BC.88/21.06.001/2007-08 dated May 30, 2008

^8. Vide Sl. No.3 in Annex to circular DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

^9. For example: The risk weight assigned to an investment in US Treasury Bills by SBI branch in Paris, irrespective of the currency of funding, will be determined by the rating assigned to the Treasury Bills, as indicated in Table 2.

^10. For example: The risk weight assigned to an investment in US Treasury Bills by SBI branch in New York will attract a zero per cent risk weight, irrespective of the rating of the claim, if the investment is funded from out of the USD denominated resources of SBI, New York. In case the SBI, New York, did not have any USD denominated resources, the risk weight will be determined by the rating assigned to the Treasury Bills, as indicated in Table 2 above.

^11. Vide Sl. No.4 of the Annex to DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

^12. Vide Appendix -1 to Annex to circular DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

^13. Added in terms of the Mail Box clarification dated June 24, 2008.

^14. For example: A Euro denominated claim of SBI branch in Paris on BNP Paribas, Paris which is funded from out of the Euro denominated deposits of SBI, Paris will attract a 20 per cent risk weight irrespective of the rating of the claim, provided BNP Paribas complies with the minimum CRAR stipulated by its regulator/supervisor in France. If BNP Paribas were breaching the minimum CRAR, the risk weight will be as indicated in Table 4 above.

^15. Claims on corporates will include all fund based and non fund based exposures other than those which qualify for inclusion under ‘sovereign’, ‘bank’, ‘regulatory retail’, ‘residential mortgage’, ‘non performing assets’, specified category addressed separately in these guidelines.

^16. Vide DBOD Mail Box clarification dated May 21, 2008

^17. Vide Sl. No.6 in the Annex to DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

^18. Vide Sl. No.4 in the Annex to DBOD.No.BP.BC.21.06.001/2007-08 dated March 31, 2008.

^19. Mortgage loans qualifying for treatment as ‘claims secured by residential property’ are defined in paragraph 5.10 below.

^20. As defined in paragraph 5.11.1 below.

^21. Vide circular DBOD.No.BP.BC.83/21.06.001/2007-08 dated May 14, 2008

^22. Vide Sl No.7 in the Annex to DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

^23. For example: (a) In the case of a cash credit facility for Rs.100 lakh (which is not unconditionally cancellable) where the drawn portion is Rs. 60 lakh, the undrawn portion of Rs. 40 lakh will attract a CCF of 20 per cent (since the CC facility is subject to review / renewal normally once a year). The credit equivalent amount of Rs. 8 lakh (20 % of Rs.40 lakh) will be assigned the appropriate risk weight as applicable to the counterparty / rating to arrive at the risk weighted asset for the undrawn portion. The drawn portion (Rs. 60 lakh) will attract a risk weight as applicable to the counterparty / rating.

(b) A TL of Rs. 700 cr is sanctioned for a large project which can be drawn down in stages over a three year period. The terms of sanction allow draw down in three stages – Rs. 150 cr in Stage I, Rs. 200 cr in Stage II and Rs. 350 cr in Stage III, where the borrower needs the bank’s explicit approval for draw down under Stages II and III after completion of certain formalities. If the borrower has drawn already Rs. 50 cr under Stage I, then the undrawn portion would be computed with reference to Stage I alone i.e., it will be Rs.100 cr. If Stage I is scheduled to be completed within one year, the CCF will be 20% and if it is more than one year then the applicable CCF will be 50 per cent.

^24. Pl. refer to item (a) of Sl.No.19 in the Annex to DBOD.No.BP.BC.67/21.06.001/2007-08 dt. March 31, 2008

^25. Pl. refer to item (b) of  Sl.No.19 of DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

^26. Pl. refer to Sl. No.8 in the Annex to DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008.

^27. For example: If in a securitisation transaction of Rs.100, the pool consists of 80 per cent of AAA securities, 10 per cent of BB securities and 10 per cent of unrated securities and the transaction does not meet the true sale criterion, then the originator will be deemed to be holding all the exposures in that transaction. Consequently, the AAA rated securities will attract a risk weight of 20 per cent and the face value of the BB rated securities and the unrated securities will be deducted. Thus the consequent impact on the capital will be Rs.21.44 (16*9 % + 20).

^28. Vide item (c) of Sl.No.19 in the Annex to DBOD.No.BP.BC.21.06.001/2007-08 dated March 31, 2008

^29. Vide  item (d) of Sl. No.19 in the Annex to DBOD.No.BP.BC.21.06.001/2007-08 dated March 31, 2008

^30. In a case where a short term claim on a counterparty is rated as P1+ and a long term claim on the same counterparty is rated as AAA, then a bank may assign a 30 per cent risk weight to an unrated short term claim and 20 per cent risk weight to an unrated long term claim on that counterparty where the seniority of the claim ranks pari-passu with the rated claims and the maturity of the unrated claim is not later than the rated claim.  In a similar case where a short term claim is rated P1+ and a long term claim is rated A, the bank may assign 50 per cent risk weight t an unrated short term or long term claim .

^31. Vide Sl No.9 in the Annex to DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

^32. A debenture would meet the test of liquidity if it is traded on a recognised stock exchange(s) on at least 90 per cent of the trading days during the preceding 365 days. Further, liquidity can be evidenced in the trading during the previous one month in the recognised stock exchange if there are a minimum of 25 trades of marketable lots in securities of each issuer.

^33. Vide  Sl.No.11 in the Annex to DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008.

^34. Vide Appendix – 2 to Annex of DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008.

^35. Holding period will be the time normally required by the bank to realise the value of the collateral.

^36. Vide Sl No.13 in the Annex of DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

^37. Vide Sl No.14 in the Annex to DBOD.No.BP.BC.67/21.06.01/2007-08 dated March 31, 2008

^38. Vide Sl No.15 in the Annex to DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

^39. Sentence added, to ensure more clarity. The para 8.3.10 of the Circular dated April 27, 2007 has been brought here.

^40. Vide Sl. No.17 in the Annex to DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008.

^41. The bullet points are added from the paragraph 718(xxii) of Basel II June 2006 document.

^42. For example: Disclosures for the financial year ending March 31, 2009 (i.e., June/ September/ December 2008 and March 2009) should be available until disclosure as on March 31, 2012.

^43. Entity = securities, insurance and other financial subsidiaries, commercial subsidiaries, significant minority equity investments in insurance, financial and commercial entities.

^44. viz. subsidiaries as in consolidated accounting, e.g. AS 21.

^44. viz. Joint ventures in consolidated accounting, e.g. AS 27.

^45. A capital deficiency is the amount by which actual capital is less than the regulatory capital requirement. Any deficiencies which have been deducted on a group level in addition to the investment in such  subsidiaries are not to be included in the aggregate capital deficiency.

^46. See paragraph 3

^47. Innovative perpetual debt instruments (or head office borrowings of foreign banks eligible for similar treatment) and any other type of instrument that may be allowed from time to time.

^48. That is after accounting offsets in accordance with the applicable accounting regime and without taking into account the effects of credit risk mitigation techniques, e.g. collateral and netting.

^49. That is, on the same basis as adopted for Segment Reporting adopted for compliance with AS 17.

^50. The industries break-up may be provided on the same lines as prescribed for DSB returns. If the exposure to any particular industry is more than 5 per cent of the gross credit exposure as computed under (b) above it should be disclosed separately.

^51. Banks shall use the same maturity bands as used for reporting positions in the ALM returns.

^52. As defined for disclosures in Table 4

^53. At a minimum, banks must give the disclosures in this Table in relation to credit risk mitigation that has been recognised for the purposes of reducing capital requirements under this Framework. Where relevant, banks are encouraged to give further information about mitigants that have not been recognised for that purpose.

^54. As defined for disclosures in Table DF-4 after application of haircuts for exposure

^55. For example: originator, investor, and servicer, provider of credit enhancement, liquidity provider, and swap provider.

^57. For example, credit cards, home equity, auto, etc.

^58. Securitisation transactions in which the originating bank does not retain any securitisation exposure should be shown separately but need only be reported for the year of inception.

^59. Where relevant, banks are encouraged to differentiate between exposures resulting from activities in which they act only as sponsors, and exposures that result from all other bank securitisation activities that are subject to the securitisation framework.

^60. For example, write-offs/provisions (if the assets remain on the bank’s balance sheet) or write-downs of I/O strips and other residual interests.

^61. Securitisation exposures, include, but are not restricted to, securities, liquidity facilities, other commitments and credit enhancements such as I/O strips, cash collateral accounts and other subordinated assets.

^62. Vide DBOD Mailbox clarification dated January 9, 2008

^63. Vide Sl N.18 in the Annex to DBOD.No.BP.BC.67/21.06.001/2007-08 dated March 31, 2008

^64. Unless all their written option positions are hedged by perfectly matched long positions in exactly the same options, in which case no capital charge for market risk is required

^65. In some cases such as foreign exchange, it may be unclear which side is the "underlying security"; this should be taken to be the asset which would be received if the option were exercised. In addition the nominal value should be used for items where the market value of the underlying instrument could be zero, e.g. caps and floors, swaptions etc.

^66. Some options (e.g. where the underlying is an interest rate or a currency) bear no specific risk, but specific risk will be present in the case of options on certain interest rate-related instruments (e.g. options on a corporate debt security or corporate bond index; see Section B for the relevant capital charges) and for options on equities and stock indices (see Section C). The charge under this measure for currency options will be 9 per cent.

^67. For options with a residual maturity of more than six months, the strike price should be compared with the forward, not current, price. A bank unable to do this must take the "in-the-money" amount to be zero.

^68. Where the position does not fall within the trading book (i.e. options on certain foreign exchange or commodities positions not belonging to the trading book), it may be acceptable to use the book value instead.

^69. Reserve Bank of India may wish to require banks doing business in certain classes of exotic options (e.g. barriers, digitals) or in options "at-the-money" that are close to expiry to use either the scenario approach or the internal models alternative, both of which can accommodate more detailed revaluation approaches.

^70. Two-months call option on a bond future, where delivery of the bond takes place in September, would be considered in April as being long the bond and short a five-month deposit, both positions being delta-weighted.

^71. The rules applying to closely-matched positions set out in paragraph 2 (a) of this Appendix will also apply in this respect.

^72. The basic rules set out here for interest rate and equity options do not attempt to capture specific risk when calculating gamma capital charges. However, Reserve Bank may require specific banks to do so.

^73. Positions have to be slotted into separate maturity ladders by currency.

^74. Banks using the duration method should use the time-bands as set out in Table 18 of the guidelines.

^75. If, for example, the time-bands 3 to 4 years, 4 to 5 years and 5 to 7 years are combined, the highest assumed change in yield of these three bands would be 0.75.

^76. Modified duration - which is standard duration divided by 1 + r, where r is the level of market interest rates – is an elasticity. As such, it reflects the percentage change in the economic value of the instrument for a given percentage change in 1 + r. As with simple duration, it assumes a linear relationship between percentage changes in value and percentage changes in interest rates. The second form of duration relaxes this assumption, as well as the assumption that the timing of payments is fixed. Effective duration is the percentage change in the price of the relevant instrument for a basis point change in yield.

^77. The duration analysis described in the previous section can be viewed as a very simple form of static.