Executive Summary

The Indian Economy is booming on the back of strong economic policies and a healthy regulatory regime. The effects of this are far-reaching and have the
potential to ultimately achieve the high growth rates that the country is yearning for. The banking system lies at the nucleus of a country's development
robust reforms are needed in India's case to fulfill that. The BASEL II accord from the Bank of International Settlements attempts to put in place sound
frameworks of measuring and quantifying the risks associated with banking operations.

The paper seeks to showcase the changes that will emerge as a result of banks adopting the international norms.

The structure of the paper is three-fold, where we begin by projecting the risk management scenario and its effects on internal operations of a bank,
followed by the changes brought about in the banking sector of India and finally the macro effects on the economy. This enables one to discern the
complete scenario that will emerge in the years ahead.

The Risk Management scenario will strengthen owing to the liberalization, regulation and integration with global markets. Management of risks will be
carried out proactively and quality of credit will improve, leading to a stronger financial sector.

The calculation of risk will be done by credit scoring models such as Altman's Z Score Model & Merton Model but in a more sophisticated and developed
manner. The management information systems (MIS) will be put in place and the level of efficiencies will increase more than proportionately. Risk based
pricing will be used for all credit facilities extended by banks. The treasury departments of banks are poised to benefit from the BASEL II accord as would
be showcased in the paper.

The future will see a structural change in the banking sector marked by consolidation and a shake-out within the sector. The smaller banks would not have
sufficient resources to withstand the intense competition of the sector. Banks would evolve to be a complete and pure financial services provider, catering
to all the financial needs of the economy. Flow of capital will increase and setting up of bases in foreign countries will become commonplace.

Finally, the economy will stand to benefit as the banking sector develops. Savings will be mobilized in the right direction and the required funds needed
for the country's development will be made available.

1.0 Introduction

The Indian Financial System is tasting success of a decade of financial sector reforms. The economy is surging and has gathered the critical mass to
convert it into a force to reckon with. The regulatory framework in India has sparked growth and key structural reforms have improved the asset quality
and profitability of banks.Growing integration of economies and the markets around the world is making global banking a reality.

Widespread use of internet banking has widened frontiers of global banking, and it is now possible to market financial products and services on a global
basis. In the coming years globalization would spread further on account of the likely opening up of financial services under WTO. India is one of the 104
signatories of Financial Services Agreement (FSA) of 1997. Thereby giving India's financial sector including banks an opportunity to expand their
business on a quid pro quo basis.As in different sectors, competition is driving growth in the banking sector also. The RBI requires all banks to comply
with the standardized approach of the BASEL II accord by 31st March, 2007. The quantification and accounting of various risks would result in a more
robust risk management system in the industry.

This paper attempts to project the implications of this transition and its effects on the internal operations of a bank followed by its effects on the banking
industry and the economy.

2.0 RISK Management Scenario in the Future

Risk management activities will be more pronounced in future banking because of liberalization, deregulation and global integration of financial markets.
This would be adding depth and dimension to the banking risks. As the risks are correlated, exposure to one risk may lead to another risk, therefore
management of risks in a proactive, efficient & integrated manner will be the strength of the successful banks. The standardized approach would be
implemented by 31st March 2007, and the forward-looking banks would be in the process of placing their MIS for the collection of data required for the
calculation of Probability of Default (PD), Exposure at Default (EAD) and Loss Given Default (LGD). The banks are expected to have at a minimum PD
data for five years and LGD and EAD data for seven years.

Presently most Indian banks do not possess the data required for the calculation of their LGDs. Also the personnel skills, the IT infrastructure and MIS at
the banks need to be upgraded substantially if the banks want to migrate to the IRB Approach.
2 topic

Over the years, banks have been involved in a process of upgrading their risk management capabilities. In doing so, the most important part of upgrading
has been the development of the methodologies, with introduction of more rigorous control practices, in measuring and managing risk. However, the by
far the biggest risk faced by the banks today, remains to be the credit risk, a risk evolved through the dealings of the banks with their customers or
counterparties. To site few examples, between the late 1980's and early 1990's, banks in Australia have had aggregate loan losses of $25 billion. In 1992,
the banking sector experienced the first ever negative return on equity, which this has never happened before. There have been many other banks in the
industrial countries, where losses reached unprecedented levels.

The analysis of credit risk was limited to reviews of individual loans, which the banks kept in their books to maturity. The banks have stride hard to
manage credit risk until early 1990s. The credit risk management today, involves both, loan reviews and portfolio analysis. With the advent of new
technologies for buying and selling risks, the banks have taken a course away from the traditional book-and-hold lending practice. This has been done in
favour of a wider and active strategy that requires the banks to analyse the risk in the best mix of assets in the existing credit environment, market
conditions, and business opportunities. The banks have now found an opportunity to manage portfolio concentrations, maturities, and loan sizes,
eliminating handling of the problem assets before they start making losses.

With the increased availability of financial instruments and activities, such as, loan syndications, loan trading, credit derivatives, and creating securities,
backed by pools of assets (securitisation), the banks, importantly, can be more active in management of risk. As an example, activities on trading in credit
derivatives (example - credit default swap) has grown exceptionally over the last ten years, and presently stands at $18 trillion, in notional terns. As it
stands now, the notional value of the credit default swap (a swap designed to transfer the credit exposure of fixed income products between parties) on
many established corporate, exceeds the value of trading in the primary debt securities, received from the same corporate. Loan syndications grew from
$700 billion to more than $2.5 trillion between 1990 and 2005, and the same period saw a growth of loan trading, which grew from less than $10 billion to
more than $160 billion. For the banks, securities pooled and reconstituted from loans or other credit exposures (asset-backed securitisation), provided the
means to reduce credit risk in their portfolios. This could be made possible by the sale of loans in the capital market. This became especially viable in case
of loans on homes and commercial real estate.

The banks are now more equipped in handling credit risk, in the allocation of its on-going credit allocation activities. Some of the banks use a more
comprehensive credit risk management system, by critically analysing the credits, considering both, the probability of default and the expected loss in the
possibility of a default. More sophisticated banks use the criteria given in Basel II accord in determining credit risk. In here the banks take credit decisions
by increased expert judgment, using quantitative, model-based techniques. Banks, which used to sanction credits to individuals relying mainly on the
personal judgment of the loan sanctioning officers, now use a more advanced method of srutinisation, applying the statistical model to data, such as credit
scores of that individual. The lending activity of a bank has its credit risk invariably embedded, as one finds in the market risk. It all such cases, banks
need to monitor risks by managing it efficiently, absorbing the risk involved.

Pricings of relevant risks are needed when-ever a bank moves in a lending contract with a corporate borrower. New analytical tools now enable banking
organizations to quantify lending risks more precisely. Through these tools, banks can estimate the measure of risk that it is taking on the fund, in order to
earn its risk-adjusted return on capital. This allows the bank to price the risk before originating the loan. Banks often use internal debt rating, or third party
systems, that uses market data to evaluate the measure of risk involved, when lending to corporate issuing stocks.

The financial Pundits of the banking sector have discussed diverse range of subjects and issues, and have arrived on four main themes for a better credit
risk management.

The first theme is concerned with a rapid evolution of techniques to manage credit risk. This evolution of techniques have been greatly supported by the
technological advancement made, with low cost computing being made available, making analyzing, measuring, and controlling credit risk in a far better
way. This has allowed introducing a more rigorous credit risk management system. However, despite the thoughts of the utilization of the techniques
evolved, implementation of these practices still has a long way to go for the bulk of the banks. However, it is expected that the pace at which the changes
are required to be introduced, will soon accelerate. With competition growing in the provision of financial services, there is a need for the banking and
financial institutions to identify new and profitable business opportunities, and as such, it is inevitable that the policies on credit management have to
change.

The second theme considered that, the ability to measure, control, and manage credit risk, is likely to be the criteria as to how the banking sector grows in
the future. Widespread cross-subsidization has introduced significant negative impact on the net interest margin of all the banks, with a profitable business
supporting the cause of otherwise non-profitable activities. The matter of cross-subsidization has been an intentional business decision by the management
of the institutions. However, this has introduced problems in cash flow, with the inability to accurately measure risk and return. With the banks getting on
to improve on their ability to measure risk and return on the activities, it is inevitable that the characteristic of the internal subsidies will become clearer.

The third theme considered the interaction between the management and the improved credit risk measurement. The theme also looked into the possibility
of using alternative risk measurement techniques within the regulatory environment. There were certain issues that emerged.

1. The role of the supervision of a bank or a financial institution, in a more competitive and a much more advanced financial environment.

2. At what extent are the banks' risk supervisory efforts and their relevant policies, keeping pace with the initiatives and developments taking place in the
market.

3. The urgent need to align the supervisory methodologies conceived, with the newly emerging risk measurement practices. In this issue, a general sense
of optimism exists, where the alignment between the banking sector and the regulatory authority, regarding the approached towards the risk management
practices, would happen over time. However, there is an obstacle in meeting the objective. The banks need to demonstrate with confidence, that they have
in place well defined, and well tested rigorous risk management models, which are completely integrated into their operational system.

The fourth and the last theme that evolved, was the need to have a firm commitment from the banking sector, relating to the management of risks in all its
forms, and the need to have a strong orientation of the credit management policy embedded within the culture of banking. Without such a firm
commitment coming from the higher levels in the banking sector, the alignment between the regulatory authorities and the banking institution, relating to
strong credit management principles, is hard to achieve. It needs to be mentioned here that, today, unless banking institutions do not take a firm committed
step towards a viable credit management system, and integrate the policies within their operational culture, it will be difficult for the sector to meet any
broader objective, which importantly includes improved shareholder returns.

In the matter to be better aligned, there is a necessity of accurate measure of the credit risk involved in any transaction that the bank makes, and such a
measure is bound to alter the risk-taking behavior, both, at the individual and at the institutional levels within the bank. So long we have been talking
about the state-of-the-art technology and its use in rigorous credit risk modeling. With this, it should be borne in mind that, improved measurement
techniques are not automatically evolved without the application of proper judgment and experience; where-ever credit or other forms of risks are
involved.