Commercial banks will be required to undertake stringent credit evaluation before taking up any inter-bank exposure.
"Banks are natural counter-parties for several transactions and it is important that a proper credit evaluation of banks is undertaken similar to the assessment done for companies," a central bank-constituted working group on credit risk has suggested.
The Reserve Bank of India (RBI) has sought banks' comments on the draft guidance note put on the RBI website.
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The note has made it clear that banks cannot take government support for granted even though "previous default experience in the financial sector has shown that governments will normally support a large bank in difficulty."
The working group has identified four key financial parameters for evaluation of any bank: capital adequacy, asset quality, liquidity and profitability.
Capital adequacy needs to be appropriate to the size and structure of the balance sheet as it represents the buffer to absorb losses during difficult times, whereas over capitalisation can impact overall profitability, the group said.
"It will be useful to calculate the capital/ total assets ratio which indicates the owners' share in the assets of the business. The ratio of tier-I capital to total assets represents the extent to which the bank can absorb a counterparty collapse," it pointed out.
The Basle standards require banks to have a capital adequacy ratio of 8 per cent with tier-I ratio at 4 per cent. The RBI requirement is 9 per cent. The Basle Committee is planning to introduce the new capital accord and these requirements could change the dimension of the capital of banks.
According to the working group, the asset portfolio in its entirety should be evaluated and should include an assessment of both funded lines and off-balance sheet items. The quality of the loan book will be reflected in the non-performing assets and provisioning ratios, while exposure to the capital market and sensitive sectors will be indicated by the high volatility, affecting both valuations and earnings.
The group has suggested special focus on those cases where exposure to a particular sector is above 10 per cent of a bank's of total assets, a significant part of the portfolio is to counter-parties based in countries which are considered to be very risky and non-performing advances which are not provided for are above 5 per cent of the loan assets.
It has also warned against rapid rates of loan growth as this can be a precursor to reducing asset quality as periods of rapid expansion are often followed by slowdowns which make the bank vulnerable.
The report also said that frequent changes in senior management, change in a key figure, and the lack of succession planning need to be viewed with suspicion. Risk management is a key indicator of the management's ability as it is integral to the health of any institution, it said.