Internal Credit Rating Practices of Indian Banks

Author(s): M. Jayadev
Source: Economic and Political Weekly, Vol. 41, No. 11, Money, Banking and Finance (Mar.
18-24, 2006), pp. 1069-1078
Published by: Economic and Political Weekly
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Internal Credit Rating Practices

of Indian Banks
The overarching goal of the second Basel accord is aligning the capital requirements of-banks
with risk sensitivity. The accord einphasises the quantification of capital requirements on the
basis of internal rating models. The internal credit rating models of banks are expected
to produce the probability of default and loss given default to estimate the capital requirements of
credit risk. This paper presents an analysis of the current status of internal credit rating practices
of Indian banks. The survey reveals that the components of internal rating systems, their
architecture, and operation differ substantially across banks. The range of grades and
risks associated with each grade vary across banks analysed. This implies that lending decisions
may vary across banks. There are differences among the rating systems of various banks. This
paper presents a set of actions to improve the quality of internal rating models of Indian banks.
M JAYADEV

he initiatives for global best practices and banking stan- other emerging markets) suffers from several limitations such
dards began with the constitution of the Basel Committee as, shopping attitude of borrowers for better rating and the
in 1975. The first Basel Accord of 1988 (Basel I) emphasised presence of a large quantum of externally unrated borrowers in
the importance of minimum capital adequacy to address credit banks' portfolios. Therefore, banks are expected to move to the
risk by devising the standardised approach. Capital adequacy is internal ratings based approach for the estimation of capital
defined as the ratio of capital funds and risk weighted assets.requirements. Moreover, the thrust of Basel II is that banks have

Here the Basel Committee adopted a portfolio approach for to make their capital requirements more risk sensitive by adopting
deciding risk weighted assets. Each asset in the balance sheetthe IRB approach. The internal rating system of a.bank has to
carries a risk weight and sum total of these products are called produce two essential components, probability of default (PD)
as risk weighted assets. In India, the Reserve Bank of India (RBI) and loss given default (LGD); a product of these two will give
has suggested risk weights of 0, 20, 50, 75, 100 and 125 per-expected loss. In this context, the objective of this paper is to
centages for various types of assets. The rule is that a bank's analyse the current internal credit rating practices of Indian banks
capital should not be less than 8 per cent (in India it is 9 perand to suggest measures to improve the quality of their internal
cent) of its risk weighted assets. However, Basel I has a number credit rating models. which ultimately helps in improving the
of limitations, particularly its insensitiveness to the risk of specificquality of loan portfolios of commercial banks. Section II of this
assets. It assumes a "one size fits all" approach by prescribingpaper focuses on architecture, design, and components of internal

a standard risk capital requirement globally.

rating models; measures to improve the quality of internal rating

models are presented in Section III.

Introduction

This paper is based on information gathered through a survey

questionnaire from 19 banks and credit rating documents of six banks.

Thus overall 25 banks are covered in this study. The loan portfolios

The New Basel Capital Accord (Basel II) addresses these of these banks, comprise 75 per cent of the total loan portfolio
deficiencies and focuses more on risk management by suggestingof scheduled commercial banks (excluding regional rural banks,
an internal rating framework for assessment of capital adequacy. cooperative banks and foreign banks) of India (Table 1). The
Basel II emphasises the allocation of risk capital for all the three questionnaire is focused on various dimensions of the architecture
risks-credit risk, market risk, and operational risks and has also and design of credit rating systems of banks. I have also interviewed

suggested a framework on indirect regulation by introducing a few senior bankers to know more about the credit decision
market discipline. Although Basel II is addressing the capital processes of various banks in rating different types of customers.
requirements of all these three risks, the issues associated with As the data was collected from the banks assuming confidenthe estimation of risk capital for credit risk are complex in nature tiality, the identities of the banks are not disclosed in the analysis.

and need to be addressed cautiously. Basel II suggests two

frameworks: the standardised approach and the internal ratings
based (IRB) approach for quantification of risk capital for credit
risk. Under the standardised approach, different risk weights
varying from 0 per cent to 150 per cent are suggested for various
categories of assets, which are intimately related with the external

ratings of various categories of borrowers.

The applicability of external ratings for estimation of capital
requirements especially in the Indian market (also applicable to

II

Survey of Internal Credit Rating Practices

What Is a Rating System?
As per Basel (2000):
An Internal rating refers to a summary indicator of risk inherent

in an individual credit. Ratings typically embody an assessment

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of the risk of loss due to failure by given borrower to pay as

promised, based on consideration of relevant counter party and
facility characteristics. A rating system includes the conceptual
methodology, management processes, and systems that play a role
in the assignment of a rating.
The internal rating model of a bank tries to capture all the risks
faced by an entity and attempts to quantify such risks in a scientific
manner. The model calibrates and communicates the risk asso-

focused on evaluating the borrower's capacity to repay the work

capital loans. The models applied for term loans are modificat

of the rating models applied for working capital limits.

Is the Borrower Rated or the Loan Facility?

A rating structure can have three dimensions. Rating can

on the basis of the characteristics of the borrower or on the basis

ciated with a borrower or a facility. Ideally, rating systemsofinspecific details of the transaction, or alternatively rating can
a bank comprise of rating methodology, rating processes, control,
be a summary indication of risk that comprises both borrower
data collection, IT systems, assignment of rating, rating transition
and transaction characteristics. The quality of credit decisions
matrix, probability of default, and loss in the event of default.
of a bank reflect in the type of rating dimension it has adopted.
If banks choose to rate both borrower-wise and transaction-wise
As per the Basel norms [BCBS 2004], an internal credit rating
system should produce mainly two important variables, PD rating
and
dimensions, a single exposure receives two types of ratings
under these two dimensions.
LGD or recovery rates. Out of the 19 banks surveyed it-is found
that only nine banks have internal rating systems that give the
The overwhelming majority of banks surveyed have explicitly
output of the transition matrix, six banks are able to generate
adopted rating of borrowers and only four banks have ratings
probability of default, and four banks are getting the data
onon
both the dimensions. In the two-dimensional rating system
recovery rates. In all the other banks, the rating system comprises
that includes a borrower and transaction grade, transaction grades

of only rating methodology and assignment of rating (Tablefor

2).different loans to the same borrower could differ. The source
Bank rating models are essentially focused on the rating
ofof
these differences is primarily the collateral attached to the
borrowers to judge their ability to pay loan interest and instalments.
transaction. For example, a borrower may take a working capital
Theoretically, internal credit rating models are an effective
loan which is normally secured against the inventory and book
instrument in the hands of banks for loan origination, pricing
Table 1: Composition of Loan Portfolios of Banks
and monitoring. Ratings facilitate comparison among the large
Participating in the Survey
number of borrowers being financed by the banks. Banks' credit
(in per cent)
rating systems are significantly.different from those of credit
Name of Advances Proportion Proportion Proportion Proportion
rating agencies in architecture and design, as well as in the Banks
uses
(in of Bills, of Term of Un- of Loans
to which credit ratings are put.
Rs crore) Cash Credit Loans secured to Comand Over- Loans mercial

Who Is Rated?

draft

Loans

Sector

Allahabad Bank 12544 53 47 11 43

Andhra Bank 11513 59 41 12 49
Fundamentally credit rating should be applicable to
all borBank of Baroda 35348 62 38 13 40
rowers. Large banks are found to apply rating models
only to
Bank of India 42633 64 36 22 36
corporate accounts while small banks are rating all Canara
types of
Bank 40472 67 33 14 49
Central Bank
borrowers seeking a minimum credit limit. On an average,
most
of India 23159 58 42 10 38
banks are assigning credit ratings to the borrowers whose
loan
Development
requirements are more than Rs 2 lakh. Apart from corporate
Credit Bank 2488 47 53 10 65
customers the next important category is borrowers from
small
Federal
Bank 6218 61- 39 8 65
Global
and medium level enterprises (SMEs) and the agriculture
sector.Trust Bank 3276 46 54 13 73
HDFC Bank 11755 44 56 14 80
Large and medium sized banks are rating borrowers whose loan
ICICI Bank 53279 7 93 3 79
requirements exceed Rs 20 lakh. These discrepanciesIndian
mayOverseas
help
Bank
17447 65 35 9 40
borrowers to take advantage of rating arbitrage. For instance,
a
Karnataka
Bank 3900 71 29 8 58
borrower may be unrated (rating is not applicable) as per
bank
OBC 15677 55 45 11 52
X-'s norms but the same borrower may be considered a rated
Punjab National
borrower as per bank Y's norms. Some banks have different
Bank 40228 59 41 7 42
State Bank
models for different categories of borrowers. These categories
of India 137758- 59 41 14 46
are formed mostly on the basis of loan limit requirement,
and
State Bank
size criteria (such as corporates and SMEs).
of Indore 5183 62 38 6 47
Seventeen of the surveyed banks are applying rating
models
State
Bank
of
Travancore 9171 66 34 13 52
to corporate borrowers; out of them five are applying
models
Syndicate
Bank 16305 56 44 23 37
to borrowers whose loan requirements meet the minimum
level
The Karur Vyasa
criteria. This limit varies from bank to bank (for example
Rs
2
Bank 3344 46 54 8 54
lakh for one bank and Rs 5 crore for another bank). The
Thirteen
South Indian

Bank 3613 55 45 17 62
banks are rating SME borrowers and six banks are concentrating
Uco Bank 15923 57 43 10 51
on rating agricultural borrowers also. Although six banks
have
Union Bank
indicated the applicability of credit rating to retail loans
of also,
India 25515 66 34 10 48
discussions with the bankers reveal that certain retail loans
such
UTI
7180
46
54
11
76

Vijaya
as educational loans and loans against shares are sanctioned
by Bank 7891 55 45 6 45
Total 551821 55 45 12 50
following certain norms instead of applying a rigorous credit
Source:
Statistical Exhibit
rating methodology. Primarily, the rating models are
more

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Figure: Grading Scales of Indian Banks

Grading Scales
8
X

6--4

t2

needed to maintain the systems integrity [Treacy and Carey

1998]. For instance, if a bank intends to use credit rating for risk

E O C , I
6

advanced uses of credit rating models for the estimation of loan

loss reserves, risk capital, profitability, for loan pricing analysis
and of ratings as inputs to formal credit portfolio risk management. Different uses place different stresses on the rating system
and may have different implications for the. internal controls

10

Number of Grades

11

capital requirement it should carefully estimate the capital requirement with proper validation and back testing of the model.

debts, whereas if it is a letter of credit it may not be secured if

How Many Grades?

the margin imposed is less than the value of the credit. The survey

finds only one bank assigns ratings purely on transaction alone.

A well functioning rating system differentiates risk within a
Rating on a transaction basis facilitates an estimation of the recovery
loan portfolio. Grades are an effective way of expressing dif-

rate, which is an essential output of an internal rating system.

ferentiation of risk categorisation of the entire loan portfolio.
Interviews with bankers reveal that some banks are practising
Differentiation of risk and pricing of loans are intimately related.
rating the transaction once the bbrrower is rated; also rating
Banks with the greatest degree of differentiation seems to be using
dimensions actually being used by the banks are not reflected
ratings in loan pricing decisions. Differentiation of risk also

in the rating model. Banks which have systems to rate facilitates

the
portfolio credit risk management and helps in formuborrower may also implicitly rate the loan facilities belonging
lation of exposure norms for each category. The survey investo that borrower. It is also observed from the credit rating
tigated the number of grades in the current rating structure, the
documents of select banks that certain risk parameters are number
exof pass grades and grades used in the watch category by
clusively applied to specific types of loan transactions. For
banks. Thirty per cent of the banks surveyed have eight grades for
example, debt service coverage ratio, an important risk factor,
the categorisation of borrowers (see the figure). The New Basel
is implicitly applied to rate the borrowers seeking term loan
Accord [BCBS 2004] suggests that for rating corporates, a bank
requirements. The sophistication desired in this direction is more
rating structure should have a minimum of seven borrower grades
for
clarity in rating dimensions, and more robust rating models
tonon-default borrowers and one for those that have defaulted.
give an idea about the recovery rates of various facilities. To facilitate easy decision making banks may categorise some
grades as pass grades for which the loan facility will be sanctioned

at an acceptable risk premium. All the banks have at least two

'Point in Time' or 'Through the Cycle' Approach?
and at most four categories which are not considered for granting

The banks I have surveyed rate the borrowers on the basisofofloan facility. A large number of grades on the rating scale
current conditions. This is called rating on the basis of point
is in
expensive to operate as the costs of additional information for
time. Whereas, under "through the cycle" approach, the borrower's
fine grading of credit quality increases sharply [RBI 2002]. The
expected condition in a downside event is primarily considered
frequency of legitimate disagreements about ratings is likely to
for rating. In this method, long-term conditions and financial
be higher when rating systems have a large number of grades.

strategies adopted by the borrower may change the ratings.

A bank can initiate the risk grading activity on a relatively smaller
Through the cycle approach may be adopted to at least largeor narrower scale and introduce new categories as the risk gradation
improves.
scale borrowers as this provides an idea on rating in an adverse
situation and helps the bank in estimating the additional capital
Table 2: Components of Internal Rating Systems of Banks
requirements during serious conditions of recession. Through the
cycle approach may be suitable to long-term loans exceeding
Components No of Banks
more than three years and the point in time approach may be

Rating methodology 18
adequate for working capital loans as these are frequently reviewed.
Rating processes 16
Control

What Are the Uses of a Credit Rating System?

Data

11

collection

IT
systems
8
Assignment of rating 16
An internal credit rating system provides many advantages
to
Quantification
of probability of default 6
Data on recovery rates 4
banks. It guides the loan origination process, portfolio monitorRating transition matrix 9
ing, analysis of the adequacy of loan loss provisions, profitability

analysis, loan pricing, risk capital allocation and incentives for

employees. All the surveyed banks are using the credit rating
Table 3: Uses of Internal Rating
system for loan origination, portfolio monitoring and reporting
Applications Number of Banks
to senior management. Fifteen banks are pricing loans on the
Guiding the loan origination process 19
basis of internal rating models (Table 3). None of the banks have
Portfolio monitoring 19
linked employee incentives with the risk grading system. Only
Reporting to senior management 19
four banks are using the models for profitability analysis
of
Analysis
of the adequacy of loan loss provisions 3
customers and only one bank is using the model for estimation
Profitability analysis 4
Loan
of risk capital requirements and comparing the regulatory capital

pricing

15

Risk capital allocation 1

requirements with risk capital. In India ratings are applied
Employee compensation 0
essentially to price loans, as the banks are yet to explore the

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Grades intended to capture heightened administrative attention

are called watch grades. Prompt and systematic tracking is required

on credits grouped in watch categories in the assessment of credit

risk. Out of the banks surveyed, 13 have watch category grades

built into the grading systems and six banks are silent about this.

Banks are expected to develop complete rating descriptions and

criteria for their assignment. Although most Indian banks have
categorised the rating structure into grades they have not described the rating grades, only five out of the surveyed banks
have supplemented the rating symbols with descriptions. One
such surveyed bank's rating description is presented in Table 4.

of current ratio whereas other banks may not regard this item
as current liability.
The standard way of using financial ratio analysis is to compare
firm level ratios with those of the same industry. But most credit
rating models do not have this feature of comparison at all. Rating
is a process involving judgment because the strength of financial
ratios may vary with various other characteristics of borrowers.
Banks also give importance to the size of borrowers represented
by sales or total assets and net worth. Many firms which do not

Who Assigns Rating?

The survey reveals that rating is being assigned at the branch
level by a credit officer in case of eight banks, whereas for seven
banks it is being done by sanctioning authorities including branch
managers. In the case of four banks. credit rating is a centralised
function. If the credit rating is a decentralised function, the scope

for subjectivity in understanding the business, industry and

management risk factors would vary and ultimately overall rating

have access to capital market resources often have low assets

or net worth. In contrast large firms have several alternative
financing avenues, more salable assets in case of a stress scenario
and firmly established market presence. For these reasons many
banks assign relatively risky grades to small firms although
their financial characteristics suggest a more favourable rating.
Table 7 shows the financial risk factors considered by a few Asian

Table 4: Risk Description

Grade Description
A++ Indicates an exceptionally high position of strength, very high degree
of sustainability

may be either understated or overstated. Unless continuous

A+ Indicates a high degree of strength on a factor among the peer group,

training is imparted for credit rating officers working at branches

and other administrative units,the consistency of the application
of the model would be doubtful.

A Indicates a moderate degree of strength with positive outlook

B+ Indicates a moderate degree of strength with suitable or marginally

high sustainability

negative outlook
B Indicates weaknesses on a parameter in comparison to peers,
unstable outlook

What Weights Are Assigned for Various Risks?

C Indicates

a fundamental weakness with regard to the factor, unlikely

to improve under normal circumstances.

The survey enquired about various risk factors considered by

Source:
banks in rating the borrowers. The overwhelming majority
of Credit rating document of a surveyed bank.
banks consider financial risk as the prime risk factor; the rest
Table 5: Weights Assigned to Various Risks (no of Banks)
of the surveyed banks may also consider financial risk as an
Weights
Financial Business Risk Industry Risk Management
important risk factor but they have not clearly indicated this.
(Per Cent) Risk Risk
Banks are assigning around 40 per cent weight for financial risk
0-20
0
4
9
9
factors. The other prominent risk factors are management risk
10
9
5
8
and industry risk (Table 5). Internationally, the best practice 20-40
is
40-60
4
1
0
1
that industry risk factors account for 20 to 30 per cent of total
60-80
4
0
0
0
score and management risk factors account for 10 to 15 per cent
18
14
14
18
of total score [Scott 2003].

Table
6:
Finan
Rating
M

What Are the Risk Factors Considered?

Financial risk factors No of Banks

Financial risk: Analysis of financial statements is central to

Current
ratio
16
appraising borrowers' financial risk. Financial risk is expressed
Debt-equity ratio (total liability to total net worth) 16
by various financial risk parameters which are computed
from,
Growth
rate or trend in sales 10
the financial statements of the obligor. These parameters
are rate or trend in net profits 11
Growth
Net
expressed as ratios between the two variables of financial
state- profit margin 14

Gross profit margin 10

ments. A wide range of risk parameters are being used in assessing
Operating profit 8
the financial risk of the borrowers (Table 6). Almost all the
Operating

leverage

leverage

surveyed banks are considering current ratio as the prime variable Interest coverage ratio 13
for rating the financial risk of borrowers. Current ratio indicates Debt-service coverage ratio 14
Cash
flows
9
liquidity of the borrower in meeting all current obligations. The
Financial

second most prominent ratio is debt-equity ratio, whichAsset

turnover

ratio

explains the relationship between total outstanding liabilitiesWorking capital turnover ratio 7
and equity. This ratio indicates the solvency position of the Return on net worth 6
Return on capital employed 13
borrower in meeting current and long-term liabilities. Among Return on assets ' 5

the profitability ratios, net profit margin, operating profit margin,

Stock

turnover

ratio

12

and return on capital employed are the important ratios. The exactDebtors turnover ratio 11
definitions of these ratios are found to vary from bank to bank. Asset coverage ratio 6

Bank borrowings to sales 3

For example. a bank may consider term loan instalments due
Any other (trends in performance, security coverage) 2

within one year as part of the current liability for the purpose

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Table 8: Qualitative Factors Considered in Analysing

banks, which reveals that the ratios considered by the Indian

banks are almost similar to many international banks.
The quality of financial information is also essential in analysing

financial ratios. Many banks are giving due importance to the

qualifications being made by auditors while analysing the financial statements of a borrower. The survey also reveals that banks
assign importance to board structure, family group, and managing

director of the company (Table 8) while rating the borrower.

Industry risk: Industry ratings are a critical element of any internal

rating system and a well designed risk rating system should

Financial Statements

Factors Considered No of Banks

Board

testing", an assessment of the family background of an apparently

healthy company [Scott 2003]. Forsetting portfolio limits, industry

risk rating is essential. Competitive scenario of the industry,

natural and artificial barriers, government policies and the general

political environment are factors generally considered while

assessing the industry risk (Table 9). Some banks are using
business risk and industry risk interchangeably whereas, others
have different weights for them. The variables considered for
business risk and industry risk are also vary widely (Appendix I

and II) across banks. Many banks have not even conceptualised
industry risk properly. The concept of business risk is also not
clear in the observed credit rating documents. Wide variations

CRISIL,

ICRA,

CARE.

etc

12

Table 9: Industry Risk

Internal Rating Mod
Industry Risk Factors No of Banks
Competition
Technology
Brand

17
14

12

Availability of substitutes 13
Environmental

risk

13

Export potential 9
Accessibility of inputs 13

Marketing

Product

network

characteristics

15
11

Barriers to entry for new players 13

Any other (specify) 5

Table

are observed in parameters considered for industry risk of select

Indian banks.

10

Credit rating assigned by external agencies such

identify potential future problems with businesses that may appear

today to be financially sound with acceptable credit risk. Industry

ratings are akin to assessing a healthy individual'> genetic predisposition to contract a medical condition. It is "corporate DNA

structure

Group to which the company belongs 11

Chairman of the company 11
Managing director of the company 10
Statutory auditors of the company 11
Important qualifications being made by the auditors 16
Disclosures according to USGAAP 8

10: Management
Rating Models

Ri

Management Risk Factors No of Banks

Management risk: Under management risk, banks judge theProfessional experience of management 18
quality of the borrower's management and assign a risk weightLabour relations 12
Professional qualifications of management 14
to this factor. Almost all banks are considering professional
Transgressions

experience of management and financial discipline of borrowersSubmission of monthl

as an important factor in assigning better ratings (Table 10). The
Financial discipline of borrowers 16
Relationship with the bank 15
professional experience of management indicates its ability to
Corporate governance 13
achieve a higher level of financial performance throughout the

business cycle and its attitude in protecting the interests of

lenders. Appendix III demonstrates management risk factorsTable 11: Other Factors (Nega
Borrowers
considered by select banks. Like business risk factors, these are
broadly worded and it is difficult for the rater to understand their Other Factors No of Banks

real meaning, especially when a large number of people are

External

Diversion of Funds 13

Delayed submission of QIS and other Financial Statements 15

involved in the rating process at different branches of a bank.

Irregularities in Documentation 12
In order to improve the utility of these factors for credit rating,
Default on Payment of LC and other Guarantees 16
banks have to focus more on continuous training and mentoring.
Dishonour of Commercial Banks 15
Irregularities in Operations of the Account 16
Other riskfactors: Most of the banks are considering some factors
Non-compliance to Terms and Conditions 14
as negative factors (Table 11) while rating the borrowers. For
Others
7

arriving at the comprehensive rating or fine rating, marks relating

Table

7:

Benc

Criteria US Bank in Asian Market Asian Bank 1 Asian Bank 2 Asian Bank 3 Asian Bank 4
Liquidity Quick ratio Current ratio Current ratio Current/Quick ratio

Leverage Debt-to-Equity ratio Debt-to-equity Debt-to-equity Debt-to-equity Equity-to-debt

Cash flow Interest cover EBITDA to total debt Cash flow/total debt EBITDA to interest EBITDA to inter
Cash flow/debt and Payables expense expense interest EBITDA to

Cash flow/sales interest expense

Profitability Pretax return on average ROI, Net income/assets. ROAE ROAE ROE
capital Gross profit margin Net profit margin Net profit margin Net income/sales

Efficiency Assets turnover, Inventory/sales Inventory/sales

Inventory/sales, Receivables/sales

Labour, production,
Sales growth rate

Growth Equity growth rate Size

Sales growth rate

Capitalisation

Sales

Source: Scott 2003.

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to these factors are deducted from the total marks computed from
all the other risk factors.

How Do Banks Arrive at the Overall

Credit Rating of Borrowers?

of internal ratings already know the agency grade for a given

borrower and have an idea of a borrower's likely position on

the internal scale. Obviously, if the agency rating is the sole
criterion used in assigning internal grades to agency rated bor-

rowers, rated and unrated borrowers within a given internal grade

might differ substantially in risk. In such circumstances the

After evaluating the borrower on various risk parameters
mapping
a
is circular because borrowers are assigned interna
credit rating model produces an overall rating of the borrower
grades based on the agency rating, and the agency rating corresponding
to each internal grade is inferred only from such rating
by aggregating the scores of various risk parameters. Most
of
assignments [Treacy and Carey 1998]. The banks I surveyed show
the banks are using simple arithmetic summation of scores arrived
that 10 out of 19 banks compare internal grading with that of
at under various risk parameters or a weighted average approach.
external rating agencies. The portion of rated advances in th
While aggregating some banks are considering the importance
total loan portfolio and amount of loans under each risk grad
of the size of the company. For example, two different companies
may have similar debt-equity ratios but a company largeris
innot
sizeavailable in the public domain. Therefore a view about
thethe
size of rated advances and composition of advances with
shall certainly have higher shock absorbing capacity than
risk grades is difficult to analyse. Hence, it is difficul
smaller size company. Once the scores are aggregated different
banks
to judge the correctness of mappings at this stage.
assign an equivalent rating. For example, one of the surveyed
banks' overall rating methodology is presented in Table 12.
Ill
Arriving at overall rating in this method is simple and easy
for implementation. However, banks may shift over to other
Improving

the Quality of Internal Rating

sophisticated multivariate techniques like logit/probit models and

Systems
discriminant analysis. These techniques will combine the various
Credit risk ratings are designed to reflect the quality of a credit
risk parameters and also produce PD, an essential parameter
required under internal rating models approach. Altman'sexposure
(1968, and explicitly or implicitly the loss characteristics of
that exposure. A consistent and meaningful internal risk rating
2002) Z score model gained popularity among the multi-variant
techniques. Thomas (2000) suggests various approaches to system
arriveis a useful source of differentiating the degree of credit

in loans and other credit exposures. This consistency and

at a single credit score by aggregating multiple risk factors. risk
Though
a few banks made an attempt to apply multiple discriminant meaning
analysisis rooted in the design of the risk rating system itself.
Considering the importance of a robust credit rating system, this
on select data on an experimental basis, there is no concrete
section outlines certain measures to improve the quality of credit
evidence of use of these models in the credit decision process.
rating system. The section is heavily dependent on the minimum
How Frequently Ratings Are Reviewed? requirements of an internal rating based approach stipulated by
Basel Accord [BCBS 2004] and the guidance notes issued by
Federal
Review of rating is an essential component of credit
riskReserve (2003).
management. Reviews are multifold: monitoring by those who
assign the initial rating of a transaction, regularly scheduled rating

Definition of Default
reviews for select exposures, occasional reviews, review at the
The generally acceptable accounting definition of default is
time of renewal of loan, yearly or half yearly review. Many banks
have agreed that they conduct yearly reviews of ratings when
(Tablethe interest or principal installment on any credit exposure
12) and the next important review is at the time of renewal
of for more than 90 days. Banks which are in the process
is due
of implementing
advanced credit rating models are recognising
loan limits. A strong review process also aims to identify
and
downgrading is also a default event. Harmonisation of default
discipline managers who produce inaccurate ratings. Suchthat
a step
definition would facilitate creation of data pool across banks.
provides strong incentives for the individuals most responsible
in identification of default is fundamental to any
for negotiating with the borrower to assess risk properly Consistency
and to
IRB system. In the Indian context, only from the year 2004
think seriously about credit issues at each stage of credit decision
making. Ratings should be reviewed by an independent onwards
credit has the delinquency norm of 90 days been introduced.
"The
of assets" may be avoided, which would dilute
risk management or loan review office both at the inception
of greening
a

the importance of a rating system in a bank. In defining the default

transaction and periodically over the life of the loan. Such reviewers

should have adequate experience and business judgmentrating

com- systems must also capture so-called "silent defaults" or

parable to that of line managers responsible for assigningdefaults

initial when the loss on a facility was avoided by liquidating
risk grades. If a bank relies on outside consultants, auditors or
Table 12: Computation of Overall Credit Rating of a Borrower

other third parties to perform all or part of this review role, such
Scores
individuals should have a clear understanding of the institution's

Gradation

Risk

Nature

credit culture and its rating process, in addition to commensurate

More than 90 1 Very Low

experience and competence in making a credit judgment.More

than

More

than

80

Low

More than 70 3 Moderately low

More
Are Internal Ratings Mapped with External Ratings?

than

60

50

Fair

Mode

rate

More than 40 6 High

More
than 30 7 Very high
Banks may compare and map the internal ratings assigned
by
Less

than

them with the ratings of credit rating agencies. This may lead
Source:
to the problem of circularity [Treacy and Carey 19981 as raters

30

Critical

Credit

rating

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docu

underlying collaterals [Federal Reserve 2003]. The rating defi-

other characteristics should not influence the obligor rating. In

nitions and criteria must be both plausible and intuitive and must

the Indian system some banks are combining these two. For
example in a 1 to 10 rating system where risk increases with

result in a meaningful differentiation of risk [BCBS 2004]. Rating

systems should be flexible enough to cope with all foreseeable

the number grade, a defaulted borrower with a fully cash secured

types of risks. Similarly, rating systems should be able to handle

all types of borrowers belonging to various businesses of different
industries [Krahnen and Weber 2001]. Useful output from a credit
rating system may be expected provided default definition and

transaction should be rated as 10 (lowest), regardless of remote

expectation of loss. Similarly, a borrower whose financial condition warrants the highest investment grade rating should be
rated as one, even if the bank's transactions are subordinate to

time horizon are consistent.

Rating Philosophy

other creditors and unsecured. Since a rating is assigned to the

obligor and not to the facility, separate exposures to the same
obligor must be assigned to the single obligor rating grade.

Bank managements should clearly -articulate whether their

internal rating system is "point in time" or "through the cycle".

Loss Severity Ratings

If the bank adopts a point in time rating system. obligors are The two dimensions of a qualifying IRB system are quanti-

grouped by probability of default frequency over the next year.

fication of default risk of borrower and risk of specific transaction.
Alternatively, borrowers may be rated on the basis of over a wideThe orientation of first dimension is that the rating of the borrower
range of possible stress outcomes, which is called through the
is same irrespective of his exposure to batik transactions. For
cycle rating system. Choosing between these two systems forms
example, he may take a partly secured working capital loan and
a rating philosophy. Point in time ratings change from year toa fully secured term loan from a bank. Regardless of the nature
year as the borrower's circumstances change, including changes
of the transaction under the first dimension, the rating would be
due to economic possibilities. Since the economic circumstancessame. Under the second dimension, the adjustment of security

of many borrowers reflect the common impact of the general

should reflect on the borrower's grade. The LGD estimate is the
economic environment, the transitions in point in time ratings
loss the bank is likely to incur in the event that the obligor defaults,

will reflect that systematic influence. Merton's (1974) probability

and is expressed as a percentage of exposure at the time of default.
of default prediction is in line with the point in time approach
LGD estimates can be assigned either through the use of a loss
of rating. Through the cycle rating systems do not estimate PD
severity rating system or they can be directly assigned to each
over the next year; instead, they assign obligors to multiple groupsfacility. A bank must estimate a long-run average LGD for each

that would be expected to share a common default frequency if

facility. Since defaults are likely to be clustered during times
the borrowers in them were to experience distress, regardless of
of economic distress and LGDs may be correlated with default
whether that distress is in the next year. This rating philosophy
rates, a time weight may materially understate loss severity per
abstracts from near-term economic possibilities and considers occurrence.
a
Moreover, for exposures for which LGD estimates
richer assessment of the possibilities. Normally external ratingare volatile over the economic cycle, the bank must use LGD
agencies follow the philosophy of through the cycle rating approach
estimates that are appropriate for an economic downturn if those

whereas banks' internal rating models are point in time. Regardare more conservative than the long run-average. LGD estimates
less of rating philosophy, the bank management must articulatemust be grounded in historical recovery rates and, where applithe implications of the bank's ratings philosophy for its capital
cable, must not be based solely on the collateral's estimated
market value. Estimates of LGD must be based on a minimum
planning process. Capital management policy should be articulated according to rating philosophy to avoid capital shortfalls data observation period that should ideally cover at least one
on times of systematic economic stress.
complete economic cycle but must, in any case, be not shorter

than a period of seven years from at least one source [BCBS

Obligor Rating Granularity

2004].

Regarding retail exposures, rating systems must be oriented

A bank must justify the number of obligor grades used in its
to both borrower and transaction risk and must capture all relevant
rating system and the distribution of borrowers across those
borrower and transaction characteristics. Banks must assign each
grades. The grade definition must include both a description of
exposure that falls within the definition of retail for IRB purposes
the degree of default risk typical for borrowers assigned the gradeinto a particular pool. Banks must demonstrate that this process

and the criteria used to distinguish that level of credit risk. The
provides for a meaningful differentiation of risk. For each pool

modifiers used or numeric grades (+ or - to alpha or Al, A2)bank must estimate PD, LGD, and EAD [BCBS 2004].
will only qualify as distinct grades if the bank has developed

complete rating descriptions and criteria for their assignment and

separately quantified PDs for these modified grades (Basel 2004).

Multiple Ratings Systems

If modifiers (such as plus or minus) are attached with ratings, A bank's size of the loan portfolio and complexity in product
banks should clarify whether these constitute a separate graderange will affect the types and numbers of rating systems employed.
or not. Bank should develop a distinct rating definition and criteria
Banks may develop one risk rating system that can be used across

for the modified grade. If a bank has diverse credit quality they
the entire commercial loan portfolio. Alternatively, a bank can
may have a greater number of borrower grades (Basel 2004).choose different rating systems for different types of portfolios.
Each obligor grade in turn must be associated with a single PD,A bank may have as many different rating systems as necessary
The rating of obligors must result in a ranking of obligors by and as few as possible. The reasons for choosing the number
PD. The borrower rating should be distinct from the loss severityof rating systems should be made transparent. For example, two
rating which is assigned to the facility and collateral as well asdifferent rating systems are required to evaluate real estate

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companies and companies in manufacturing activity. Similarly

the bank should not divide the set of companies into too many
subsets and construct too many different rating systems. Certain

companies may fall into more than one rating system and create
a difficulty in back testing due to the relatively smaller number

of data points [Krahnen and Weber 2001]. Banks may combine

rating models for some loans and expert judgment systems for
others. The bank must document the rationale for assigning a

Data Maintenance

Indian banks have not paid much attention to storing of def

data on each type of loan by risk grade. Even if they have

so, the data is available on regulatory categorisation loan
not on the basis of risk grades. Under regulatory categoris
also the norms for categorisation of bad loans is not uniform

the last six or seven years. Therefore, banks have to ma

borrower to a rating system. However the aim of use of multiple

beginning in collection and maintenance of different loans a

rating systems should not be to minimise capital requirements

loan performance and grading. A bank must collect and

data on key borrower and facility characteristics to pro
effective support to its internal credit risk measurement
management processes. Banks must maintain rating histori

inappropriately [BCBS 2004].

Informational Efficiency
A rating system should accommodate all the available information and such information should be modelled correctly in the
rating. The current credit rating of a borrower should be the best
basis for predicting tomorrow's rating. The rating system should

cope with splitting bias. Splitting bias suggests that presenting

an attribute more in detail may increase the weight it receives.
Credit officers may have the tendency to rate qualitative criteria
of a rating system better than quantitative ones and they tend
to change qualitative variables less than quantitative [Krahnen
and Weber 2001].

borrowers and recognised guarantors, the dates the ratings

assigned, the methodology and key data used to derive the r
and the person or mode! responsible for rating. The identi

defaulted borrowers and facilities, the timing of default

circumstances of such defaults must be retained.

Validation Process
Banks must implement a process to ensure the accuracy of

rating systems. Banks must have a robust system in pl

validate the accuracy and consistency of rating systems, pro

and the estimation of all relevant risk components [BCBS

Documentation of Rating Systems

Banks must document in writing their rating systems design
and operational details. The documentation is an evidence of the
bank's compliance with the minimum standards and must address
topics such as portfolio differentiation, rating criteria, responsibilities of parties that rate borrowers and facilities, definition

Rating system accuracy is a combination of two things - the

long-run average default frequency for each rating grade
significantly greater than the PD assigned to that grade an

actual stress condition loss rates experienced on default

cilities are not significantly greater than the LGD estim
assigned to those facilities. A bank must demonstrate t

of rating exceptions, parties that have authority to approve

supervisor that the internal validation process enables it to

the performance of internal rating and risk estimation sy

exceptions, frequency of rating reviews, and management oversight of the rating process. Rating criteria and procedures must
be periodically reviewed to determine whether they remain fully
applicable to the current portfolio and to external conditions. If
the bank employs statistical models in the rating process the bank

concisely and meaningfully. While doing validation, est

of PDs, LGDs and EADs are likely to involve unpredict
errors. In order to avoid over optimism, a bank must add
estimates a margin of conservatism that is related to the
range of errors. Where methods and data are less satisf

must document their methodologies [BCBS 2004].

and the likely range of errors is larger, the margin of conser

must be larger [BCBS 2004].

Minimise the Error of Human Judgment

Undoubtedly the rating process involves the exercise of human
judgment while considering the assignment of rating and weight

Back Testing
Banks must establish internal tolerance limits for differences

given to each factor. Among the surveyed banks almost all of

between expected and actual outcomes. The ex-ante default

them are using judgmental rating methods for rating the borrow-

ers on management and industry risk parameters. Different

should not be significantly different from the ex post default

frequency. Back testing in credit risk management is difficult

individuals in the same bank may understand certain risk param-

because of non-availability of market prices for loans. The historical

eters differently. This is more pertinent while rating the borrowers

data on credit defaults is also limited. Therefore, pooling of

resources across different banks may create a better data base
which facilitates improved back testing. Back testing is a focal

on industry risk and management risk. For example, almost all

the banks are assigning weights to the competition while assessing
the business risk. For the credit officer at the branch level it is

point for validating rating, the need for it yields some important

implications for the design and use of ratings.

difficult to comprehend the concept of competition. He may

consider purely local factors of a specific geographical area while

the firm may face competition from non local units and ultimately
Credit Risk Control
the borrower may encountercompetition risk substantially. Unless
the bank provides rigorous training to all users of the model, the Banks must have independent credit risk control units that are
degree of objectivity will be very low in evaluating business and
responsible for the design, implementation and performance o

industry risk factors. The rating system should be identical

their internal rating systems. The unit must be functionally
regardless of the person who rates. It should stand for the test
independent from the personnel and management function
responsible for originating exposures. Areas of responsibilit
of stationarity propertyl [Krahnen and Weber 2001].

1076 Economic and Political Weekly March 18, 2006

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Appendix I: Business Risk Factors

must include: (a) Testing and monitoring internal grade.

(b) Production and analysis of summary reports from the bank's
rating system to include historical default data stored by rating
at the time of default and one year prior to default, rating migration

analysis and monitoring of trends in key rating criteria.

(c) Implementing procedures to verify that rating definitions are

consistently applied across departments and geographic areas.

(d) Reviewing and documenting any rating changes to the rating

process, including the reasons for the changes. (e) Reviewing

the rating criteria to evaluate if they remain predictive of risk.
Changes to the rating process, criteria or individual rating parameters must be documented and retained for supervisors to
review. A credit risk control unit must actively participate in the
development, selection, implementation and validation of rating
models.

Bank X

1 Past commitments with respect to net sales.

2 Past commitment with respect to net profit.

3 Conduct of the account

4 Compliance of terms and conditions

5 Income value of the Bank (Interest, commission, exchange, etc, from the
account as percentage of total fund based limit)
6 Repayment of installment (for term loan)
7 Security coverage (collateral)
8 Trend analysis
(a) Trend analysis-variation in net current assets
(b) Trend analysis-variation in tangible net worth
(c) Trend analysis-profitability (net profit/net sales or receipt)

Bank Y

1 Market position/Current market share

2 Operating efficiency

3 Growth

1 Market position/Current market share

Products

Corporate Governance

Product range (single product dependence or wide range of products)

Consistency of quality (approach toward quality assurance)
Support service facilities (ability to provide service after sales)
Customisation of product (ability to provide customised products)
Shelf life of product.

All material aspects of the rating and estimating processes must

Prices
be approved by the bank's board of directors. These parties must - Pricing flexibility (flexibility to increase prices in line with costs)
_Brand equity
process a general understanding of the bank's risk rating system

and detailed comprehension of its associated management re- - Bargaining power with suppliers (to control cost of input effectively)
- Bargaining power with buyers (whether monopolistic, etc)
ports. Senior management must also have a good understandingPlace (Selling/Marketing)
of the rating system's design and operation and must approve - Distribution set-up
- Geographical diversity of markets (both domestic and international)
material differences between established procedure and actual - Long-term contracts/assured off take
practice. Management must also ensure on an ongoing basis, thatPromotion (based on needs/competition)
the rating system is being operated properly. Management and - Advertising expenditure (required as well as ability to sustain)

- Other promotional ventures (whether undertaken and whether beneficial)

staff in the credit control function must meet regularly to discuss2 Operating efficiency
Raw material
the performance of the rating process, areas needing improvement

and the status of efforts to improve previously identified deficiencies. Internal ratings must be an essential part of the reporting

Related risk and mitigation

Availability of raw materials
Import content substitution (degree of indigenisation)
Management of product price volatility

Capacity utilisation
Management of operative cost (employee/energy/technology)
Management of selling costs.
Technology adoption
Location advantage.

to these parties. Reporting must include risk profile by grade,

Manufacturing and selling
migration across grades, estimation of the relevant parameters - Overall cost structure advantage/disadvantage form

per grade, and comparison of realised default rates against

expectations. Reporting frequencies may vary with the significance and type of information and the level of the recipient. Senior

management must provide notice to the board of directors for

Others
any material changes or exceptions from established policies that - Availability of utilities (power/water, etc)
will impact the operations of the bank's rating system.
- Adherence to environmental/domestic/international regulation

Internal and External Audit

- Foreign exchange earnings

- Working capital management

3 Growth

- Increase of net sales over last year (per cent)

- Increase of operating profit margin over last year (per cent)

Market testing is possible for external ratings but for internal

- Debtor's velocity (months)

ratings there is no external check. Testing for neutrality of internal
Bank Z
Competition
ratings is a serious test of rating methodology and rating1per-

- There is no competition in the nearly area

formance. Internal audit or an equally independent function must
- Competition is existing but not a threat

review at least annually the bank's rating system and its opera- Company has to exist among stiff competition/faces
growth
tions, including the operations of the credit function and the
- Heavy competition leading to insipid growth
estimation of PDs, and LGDs. Internal audit must document its

difficulty in sustaining

2 Locational advantage
- Located in an area with huge demand
- Located among competitors but standing is long (> 10 years)

findings.

Conclusion

- Located among competitors but with a standing of 5 to 10 years.

- No locational advantage

3 Commodities traded

- ' Traded commodities have consistent demand with no seasonal fluctuation

The components of internal rating systems, their architecture
- Demand fluctuation would not impact the growth
and operation differ substantially across the surveyed banks.
The fluctuation results in constant revision according to market
-Demand
trend
range of grades and risks associated with each grade vary across
- High fluctuation on demand leading to poor growth
the banks analysed. This implies that lending decisions may
vary
4 Market perception
across the banks. There are differences among the rating systems
- Cash and carry business leading to constant cash flow
Available credit from supplier matches extension of credit to customers.
of various banks. No single rating system is best for all -banks.
- Largely dependent on credit sales with satisfactory realisation
Building an internal rating system and implementing it success- Largely dependent on credit sales but realisation is poor

fully to get the desired result is a complex task in a banking entity.

Economic and Political Weekly March 18, 2006 1077

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Appendix II: Industry Risk Parameters

Bank X

I Present industry/activity scenario dealt by is favourable.

2 Technology/activity is proven for medium-term.

3
4
5
6

Demand of the product is increasing.

Availability of raw material/ products (traders) is adequate.
Industry/activity does not depend on the vagaries of nature.
The products have established markets.
7 Quality of product is satisfactory.
8 Product range/mix is satisfactory.
9 Threat of substitute/competitors to the product/s is not there.

In this process human judgment plays central role and a variety

of possible uses of ratings can influence the rating decisions. Thus

banks have to design carefully controls and internal review

procedures for the effective implementation of internal rating
systems. Internal rating systems promote a credit culture in the

organisation. It should hold managers accountable for credit

quality. The banks should consider critically the culture factor

in designing rating systems.
Internal rating systems are expected to operate dynamically.
10 Firm is not assembler or trader of unbranded items.
As ratings are assigned, quantified and used, estimates will be
Bank Y
compared with actual results, data will be maintained and updated
1 Industry characteristics
- Importance to economy (in terms of industry size/contribution
to to
support oversight and validation efforts and for better future
production/exports/employment generation/forward and backward
estimates. Rating systems with appropriate data and oversight
linkages)
feedback mechanisms foster a learning environment that pro- Cyclicality (impact of cyclical fluctuations on industry performance)
- Sensitivity of the industry to government policies (duties/price controls
and licensing or environmental norms)

- Growth potential/outlook of the industry (best estimate of next five

years' average annual growth per cent)
2 Competitive forces
- Extent of competition among domestic/international players
- Threats of imports/substitute/unorganised sector
- Technology risk(does industry require constantly changing technology
or R&D/rate of obsolescence of technology)
- Barriers to entry for new players (interims of technology, high cost, long

gestation perod)
- Bargaining power of buyer industries
- Bargaining power of supplier industry
- International competitiveness
- Fluctuation and demand-supply gap
3 Industry financials

motes integrity in the rating system as well as continuing refinement. Internal rating systems need the support and oversight of

the board and senior management to ensure that the various

components fit together seamlessly and those incentives to make
the system rigorous extend across line, risk management and other
control groups. In the absence of strong support and involvement
of board and senior management, rating systems are unlikely to
provide accurate and consistent risk estimates during both good
and bad times. 1[3

Email: [email protected]

Note

- Retum on capital employed - ROCE (three years industry average per cent)

- Operating margins (three years industry average per cent)

- Earning stability

Appendix III: Management Risk Factors

Bank X

1 Management is an established player for more than five years.

2 Have good reputation and track record.
3 Have satisfactory relations with the bank for more than three years.
4 Business is not managed by one or two persons.
5 Management is financially able to withstand competition.
6 Borrowers not dealing in perishable goods.
7 Future growth potential is high.
8 Borrowers are not dependent on limited suppliers.
9 Business is not cyclical or there are no cyclical earnings.
10 Borrowers not dependent on limited customers.
11 Market share is satisfactory and acceptable.
12 Distribution set-up is satisfactory.

[This paper is part of the research report entitled 'Basel-II and Credit Risk'
submitted to the Indian Institute of Banking and Finance, Mumbai. Author
wishes to express gratitude to the anonymous referee and to Joshy Jacob
for their useful comments on this paper.]
1 A PD is based on an ex-ante point of view. It states that a company within

PD 0.7 per cent has a 7 in a 1,000 chance to be default within a given

time period. We know from research on capital markets that testing
expectations is always tricky. In order to relate (ex-ante) expectations of
(ex-post) observed data, we have to assume that the structure of the problem

under consideration remains constant from the date where expectations

are formed to the date where observations are taken. This assumption is
called the stationarity assumption.

References

Bank Y

Altman, I Edward (1968): 'Financial Ratios, Discriminant Analysis and

Compulsory parameters/track records

1 No of years of experience in industry

Prediction of Corporate Bankruptcy', Journal of Finance, 23, ppl89-209.

- (2002): Bankruptcy, Credit Risk and High Yield Junk Bonds, Blackwell

2 Quality of management personnel

3 Percentage of actual sales achieved to projections made last year.

Publishers.

Basel (2000): Range of Practice in Banks' Internal Ratings Systems, January.

4 Percentage of net profit achieved to projections made last years.
BCBS (2004): International Convergence of Capital Measurement and Capital
5 Percentage of actual net working capital to projections made last year.
Standards, Basel Committee on Banking Supervision, June.
6 Payment record to bankers/institutions

Federal Reserve (2003): 'Draft Supervisory Guidance on Internal Ratings

Based Systems for Corporate Credit', July 1.

Other relevant parameters

1 Group support
2 Management succession
3 Corporate governance
4 Credibility

Krahnen Jan Peiter, Martin Weber (2001): 'Generally Accepted

Rating Principles: A Primer', Journal of Banking and Finance, 25,

pp 3-23.

Bank Z

Merton, R C (1974): 'On the Pricing of Corporate Debt: The Risk Structure
Management quality:
of Interest Rates', Journal of Finance, 29, pp 449-70.
1 Management experience
- The promoters have been in the trade for more than a decade and RBI
are (2002): 'Guidance Note on Credit Risk Management', Reserve Bank
of India, October.
well experienced

Scott, Roman (2003): 'Credit Risk Management for Emerging Markets:

- The promoters are in the trade for over five years, but less than 10 years
Lessons from the Asian Crisis', in Gordian Gaeta (ed), Frontiers in Credit
- Promoters are in the trade for less than five years
- Management is totally new in venture

2 Succession planning
- Family business and no cause for concern

- Promoters are young and have family back up

- Promoters are old but succession by family members is expected
- Promoters are old and no back up for succession

Risk, John Wiley and Sons (Asia), Singapore.

Thomas, Lyn C (2000): 'A Survey of Credit and Behavioural Scoring:

Forecasting Financial Risk of Lending to Customers', International Journal

of Forecasting, No 16, pp 149-72.

Treacy, William F, Mark S Carey (1998): 'Credit Risk Rating at Large US
Banks', Federal Reserve Bulletin, November, pp 897-921.

1078 Economic and Political Weekly March 18, 2006

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