Indian banks are facing issues associated with risk management and capital adequacy due to structural increase in their non-performing assets (NPAs) resulting in write downs and losses. Credit risk is the largest element of risk in the books of most scheduled commercial banks (SCBs). Therefore, a robust credit risk management system must be established in banks that should enable the top management to know how much credit risk to accept for strengthening the bottom line. Banks should have a keen awareness of the need to identify, measure, monitor and control credit risk as well as to determine that they hold adequate capital against these risks and that they are adequately compensated for risks incurred.
The internal rating-based (IRB) approach is one of the most innovative elements of the New Capital Adequacy Framework (NCAF) stipulated by RBI. It allows banks themselves to estimate certain key risk elements in the calculation of their capital requirements against credit risk.
Of the 17 SCBs that had applied for adopting the IRB standards, RBI has considered only four important nationalised banks and three leading private sectors banks to work together as parallel (in 2013-15). It has two stages: Foundation Internal Rating-Based Approach (FIRB) and Advanced Internal Rating-Based Approach (AIRB).
Under FIRB, banks are allowed to develop their internal empirical model to estimate the PD (probability of default) for their obligors. Other factors like loss given default (LGD) and exposure at default (EAD) will be given by the regulator. Under AIRB, banks will have to use their own quantitative models to estimate all risk elements required for calculating the risk-weighted asset (RWA). Then total required capital is calculated after multiplying the estimated RWA by 9%.
Under the IRB approach, banks must categorise banking-book exposures into broad classes of assets with different underlying risk characteristics. The classes of assets are corporate, sovereign, bank, retail, and equity. Within the retail asset class, three sub-classes are separately identified. For every asset class, banks need to internally develop rating models that provide frequent updates and early warnings of changes in borrowers’ credit quality including default. The rating models must look at borrower character, capital structure, capacity to pay, collateral attached to the loan and business cycle conditions to predict future default risk. Internal ratings allow to measure credit risk and to manage consistently a bank’s credit portfolio. Robust data management process to develop internal rating models (corporate, SMEs,