Effectiveness of Internal Rating Systems in Public Sector Banks of India

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.