Concentration Risk, Expected Loss and RAROC on a Road SPV
The DFI's credit risk committee is reviewing its ₹80,000 crore loan book. Tier-1 capital is ₹9,000 crore. A single road SPV has drawn exposure of ₹1,200 crore; the internal single-borrower limit is 10% of Tier-1 capital. The roads sector exposure is ₹20,800 crore against an internal sector cap of 20%. The SPV is rated internally BBB; the risk team assigns a 12-month PD of 4% and an LGD of 45% for the secured term loan. The account currently carries a standard-asset provision of ₹12 crore. The relationship manager reports a yield of 10.5% on the exposure, while the DFI's marginal funding cost is 7.2%. The committee must decide whether to approve a further ₹150 crore capex loan for the same SPV and how to treat the existing position in the quarterly risk report.
1. Compute expected loss, the provision gap and a simple RAROC. Advise on the ₹150 crore capex request.
Read the worked answer
EL = EAD × PD × LGD = ₹1,200 crore × 4% × 45% = ₹21.6 crore. Existing provision = ₹12 crore, so the provision gap is ₹9.6 crore.
Simple RAROC: spread income = ₹1,200 × (10.5% − 7.2%) = ₹39.6 crore; minus EL = ₹18.0 crore; capital at 12% of EAD = ₹144 crore; RAROC = 18/144 = 12.5%, below a 15% hurdle. The ₹150 crore capex loan would add EL of ₹2.7 crore and take single-borrower exposure to ₹1,350 crore, or 15% of Tier-1 capital.
Recommendation: do not approve the incremental loan on the current terms. Either decline, require a guarantee or credit enhancement that lowers LGD, price it above the hurdle, or reduce the existing exposure first. The provision gap should be topped up in the current quarter, not smoothed over future periods. A BBB rating with a 4% PD is not automatically unacceptable, but at this spread it does not clear the risk-adjusted hurdle.
2. Assess the single-borrower and sector-limit position. What governance actions should follow a breach?
Read the worked answer
Single-borrower exposure is 1,200/9,000 = 13.3%, above the 10% internal cap; the excess is ₹300 crore. Roads exposure is 20,800/80,000 = 26%, above the 20% sector cap; the excess is ₹4,800 crore.
These are governance breaches, not just reporting items. The committee should escalate to the board risk committee, freeze new roads sanctions until a remediation plan is approved, and set a time-bound plan to sell down or syndicate part of the exposure. A temporary limit can be approved only with a documented rationale, a hard end date, and a capital plan.
The DFI should also review whether the cap is measured on drawn exposure or sanctioned exposure; using drawn exposure can hide pipeline concentration. Sector sub-limits (operational roads, under-construction roads, state guarantees) would prevent the same risk from re-entering through a different product.
3. Run a stress case where PD doubles to 8% and LGD rises to 55%. Recalculate expected loss, explain the capital and P&L impact, and propose mitigants.
Read the worked answer
Stressed EL = ₹1,200 × 8% × 55% = ₹52.8 crore; with the new loan, ₹1,350 × 8% × 55% = ₹59.4 crore. The provision gap rises to ₹40.8 crore on the existing exposure, which would hit P&L and capital. If the DFI uses a 12% capital allocation, the capital charge is unchanged at ₹144 crore for the existing exposure, but the risk-adjusted return falls: spread income ₹39.6 crore − EL ₹52.8 crore = negative ₹13.2 crore, so the account destroys value in stress.
Mitigants: obtain a corporate guarantee or partial credit guarantee, tighten the cash sweep and DSRA, reduce the ticket through sell-down, and diversify the roads sub-sector. Pricing should include a stress premium, not just the base-case spread. The committee should also run a correlation scenario: if two large road SPVs are stressed together, the sector cap breach becomes a capital problem, not only a limit exception.