The challenge before the Indian banks is the implementation of the new Basel framework, more popularly known as Basel II, as laid down by the Basel Committee on Banking Supervision (BCBS). This has severe implications for credit risk practices in Indian banking, the way banks appraise credit proposals, price loans, manage credit risk at the individual and portfolio level, and also manage their NPAs. Indian banks have been preparing and implementing various measures for effective management of credit risk. One such measure is the development of internal rating models mostly in collaboration with the external agencies and banks have been using them for rating their loan accounts. This paper examines the internal credit rating models of public sector banks and tests their effectiveness using multiple criteria. All the models have exhibited poor performance (weaknesses) in at least one criterion. However, the level of weakness varied widely across the models. The findings tentatively support our hypothesis that the presence of weaknesses in the existing credit appraisal is a major cause of accounts turning into bad loans.

The financial sector reforms have brought in a number of far-reaching changes in the operational arena of banking both in respect of approach and procedure. One such important dimension is Risk Management. Banks, in their course of business, are confronted with various kinds of financial and non-financial risks: credit risk, market risk and operational risk. Risk management in banking has gained prominence following the RBI’s decision to implement Basel II. As per the Central Bank’s directive, all the banks need to fully migrate to the Basel II framework by March 31, 2009. This requires all loans to be rated by the banks using banks’ internal risk rating models. Accordingly, Indian banks have developed internal models mostly in collaboration with the external agencies and have been using them for rating their loan accounts. Internally though banks are constantly re-evaluating the predictive power of the internal risk rating models, externally none of the researchers have reported the effectiveness of these models in the context of requirements of Basel II (Refer Box 1) and as default predictor.

While there is a growing empirical literature on validity and reliability of credit risk models in general and external ratings in particular, there is still very little published work on the methodology and empirics on internal ratings. Most research on internal ratings has focused on examining the general design of banks’ internal rating systems and suggesting how specific design choices are likely to affect the eventual functioning of Basel II (Treacy and Carey, 1998; and Crouchy et al., 2001). However, some recent studies (Hayden, 2003; and Jacobson et al., 2003) have focused on evaluation of internal ratings of banks in two countries. The available literatures are mainly on the various aspects of credit risk management with and without reference to Basel II. Though some of the papers tried to examine some of the aspects of internal rating systems, none of the researchers has reported about the effectiveness of rating models adopted by banks in view of Basel II requirements.

Bank Management Journal, Indian Banks, Asset Liability Management, Data Filtering, Least Absolute Deviation, Decision-Making Group, Commercial Banks, Ordinary Least Square, Banking Industry, Kenyan Banks, Least Squares Regression, Mutual Fund Industry, Linear Programming, Financial Markets, Capital Required Adequacy Ratio, Public Sector Banks.