banks credit rating

8/11/2019 Banks Credit Rating

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Presented by : Dr. Peter Larose


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Banks Credit Rating

Sit Back,

Relax,

Enjoy,

The Presentation


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1. What is credit rating?2. Why the need for a credit rating?

3. Who are the credit rating agencies?

4. Factors influencing change in banks rating,

5. Rating definitions used by Standard & Poors (S&P),

6. S&P criteria for rating,

7. Where do the Taiwanese banks fit?

8. The role of rating agencies,

9. Use of external rating scales,

10.Internal ratings,11.Banks rating methodology,

12.Financial ratios used by S&P,

13.Taiwan banking outlook, and

14.What have we learnt?

Focus of this Presentation


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Banks Credit Rating

A credit rating is an evaluation report of how well or bad

a company is performing in absolute terms in a particular

market or industry.

Such a report makes it possible for the stakeholders to

compare a companys credit worthiness against other

companies operating in similar market or industryinternationally.

The rating exercise is considered as one of the most

essential reports, besides the External auditors report,which provides the stakeholders an overview of the

financial standing of the commercial entity.

The report is made up of both; (a) quantitative, and (b)

qualitative information.


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Banks Credit Rating

Why the Need for a Credit Rating?

(a) The financial sector especially the banking industry in

most emerging economies is going through a process

of change,

(b) Financial transactions have become a major economic

activity in most service-based economies, thus any

disruption or imbalance in its infrastructure will have asignificant impact on the whole economy,

(c) A safe and sound banking industry can bring about

stability within the financial markets,

(d) During the last decade, banks around the world had to

respond to the emerging challenges of competition,

risks and uncertainties,


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Banks Credit Rating

Why the Need for a Credit Rating?

(e) It is considered part of the Corporate Governance

principlesfor a commercial entity to practice good

governance, especially banks,

(f) The stakeholders normally expects such a report as

part of their overall assessment of the companys or

banks financial soundness and stability,

(g) Analysts and investors can compare a company or banks

performance with another company or bank operating in

the same market or industry internationally, and

(h) Depending on the jurisdiction, the companies or banks

listed on the Stock Exchange must fulfilled such a

requirement as part of the regulatory and commercial

laws.


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Who Are the Credit Rating Agencies?

There are at least 74 Credit Rating Agencies around the

world. Just to name a few:

Country Name

Australia Australian Rating

International Standard & Poors

International Moody's Investors ServiceEurope Central European Rating Agency

Europe Fitch/IBCA

Japan Nippon Investors Service

Japan Japan Credit Rating Agency LtdTaiwan Taiwan Ratings Corporation

India Credit Rating Information Services of India

China Shanghai Far East Credit Rating Co Ltd.

Russia RUS Ratings



Factors Influencing Change in Banks Rating

Higher Rating

* Ability to generate sound, stable earnings and capital overtime (inc lusive of bo th the regulatory and economic capi tal)

The prevailing political stability in the country, where the

banks are operating (upgrade of the BFSR by S&P focus onpreferent ial capita l , and sub ordin ated debts).

Application of conservative risk metrics (e.g. credit , interest

rate, foreign exch ange rate), and

Consistent earnings a fundamental underpinning factor

for any rating exercise.



Factors Influencing Change in Banks Rating

Lower Rating

Major legislative changes that affect the banks in theoperating jurisdiction(e.g. new taxes on banks profits),

Significant decline in the banks profits (say 35%),

Material alteration to the Governance structure could

presage a downgrade,

Breach of securities covenants, and

Failure to comply with any regulatory capital requirement

based on the jurisdiction regulatory rules.



Ratings Definitions Used by Standard & Poors

The rating services use a 9-point rating scale based on the

following symbols:

1. A has a Very Strong fundamental strength compared

with that of its global peers.

NB: It is the highest BFSR assigned by Standard Poors

2. B+ - show the higher relative standing with its rating category.

3. B - has a Strong fundamental strength.

It is more susceptible to the adverse effects of changes in circumstance

economic conditions than those entities rated as A

4. C+- show the higher relative standing with its rating category.

BSFR means Bank Fundamental Strength Ratings by S&P



Ratings Definitions Used by Standard & Poors

5. C has adequate fundamental strength.

It is more sensitive to uncertainties and adverse circumstances

to a greater degree than higher rated entities.

6.D+ - show the higher relative standing with its rating category.

7. D - is vulnerable to a greater degree than those banks

rated higher, to adverse circumstances in its

operating environment.

8.E+ - show the higher relative standing with its rating category.

9.E - is likely to be facing significant weaknesses in its

fundamental credit profile and may be in default

on some or all of its financial obligations.

It is the lowest BFSR assigned by Standard Poors.



BSFR represent an S&P opinion of a banks

fundamental strength, or more specifically, whathas been formally referred to as status quo rating

on the bank.

Different rating agencies use different methodology.

BSFR assessment of what a single legal entity

within a group would be rated, which incorporate

the benefits or burden of being part of the group.

A BSFR would not include any potential capital

assistance from the group, regulator or Government



S&P does consider the following factors when

assessing a banks fundamental strength rating(BSFR):State of the economy,

Industry structure,

Regulatory environment,

Degree of competition,

Status of business,

Scope of geographic diversification & distribution,

Quality assets & investments,

Credit and market risk appetite,Funding & liquidity position,

Capitalization, profitability & risk management structure,

These factors are embodied in a business & financial riskmodel.



These risk factors include actions or inaction by the

Govt, conducted in its normal course of activity,that may directly or indirectly affect banks.

Direct EffectsChange by the Government

Regulator changes:

tax regime,

lending requirements, &

other regulations.

Indirect EffectsDecline in value of bonds,

Adverse change in external

balance of payment (BOP),

Increase credit leverage,

Increase money-marketvolatility.



A BSFR is a form of long-term issuer credit rating.

It must be noted that it is neither a counterparty credit rating

nor a substitute for one.

Normally, it complements a traditional counterparty credit

rating and it is intended to provide additional information

to all the stakeholders of banks.

A bank, which does not have a credit rating may be faced

with uncertainties for its future operations.

This is due that the business of banking is about information

which customers, investors, stock markets, lenders are

demanding all the time.



While, we discuss the credit rating for banks around the

World, irrespective of the jurisdiction, where they operate,It is vital, that we ask

where do the Taiwanese banks fit with the Asia- Pacific

banking market?

The next slide addresses this question based a research

findings carried out by Standard & Poors.

The research takes into consideration the level of economic

risk vs the business risk.

& f S



Economic & Industry Risk in Asia-Pacific Banking Systems

ECONOMIC RISK

Very

High High

Moderately

High Moderate

Moderately

Low

L

o

w

Low Australia

Moderately

Low

New Zealand

Singapore

Moderate HongKong

Malaysia

Moderately

High

Thailand

South

Korea

Taiwan

Japan

High ChinaPhilippines India

Very High IndonesiaVietnam

INDUSTRY

RISK

Source: Standard & Poors : Asia-Pacif ic Bankin g Outloo k 2005



The role of the rating agencies within the reformed Capital

Accord is predetermined by their being the only globally

accepted benchmarks for the banking industry.

For this reason, the credit risk management functions of

many financial institutions & banks have been built on the

basis of methodologies comparable to the major externalagencies.

A key objective/function of the reform process is to build

on approaches already inherent and actively used by banks

As such the external rating methodologies must play an

Important role in any reform process.



The role of rating agencies is also important given the

standing of public ratings within financial markets.

Reliance on the rating agencies for providing background

analysis & ratings for external rated names also

compounds the level of penetration of rating agency

methodologies into banks rating processes.



The factors that allow banks to continue to promote the use

Of the rating agencies scales are as follows:

(1) Publicly Available Data Set

Moodys & Standard and Poors have made their internal

default and recovery information publicly available to any

interested party.

These data products are now widely used by the industry

to feed models used within the credit risk management

processes.

(2) Market Forces

The credit derivatives and asset securitization markets

have requirements for public ratings.



(3) Quantitative Ratings

Rating agencies have begun to develop more quantitative

ratings, which provide useful benchmarks for internal

rating models.

Regulatory Grades

An approach using more rating grades should be preferred.

If a counterparty lies at the boundary of two rating grades,

the capital impact of a rating difference is reduced

significantly with more rating grades.



Since many financial institutions define their internal rating

processes differently, it is useful that minimum standards

are established for the model approval of internal ratings.

In this respect, it is very important for Basel Accord to focus

on the development of a minimum standards on banks

overall internal rating processes, not just the rating models

used within these processes.

It is generally accepted by banking specialists that the

processes required to set globally consistent ratings will

depend on:

(a) Credit policy applied, (e) Risk Review,

(b) Credit culture, (f) Credit Forum, and

(c) Rating models, (g) Delegated Authorities.d Peo le,


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Banks Credit Rating

Credit Policy AppliedThis should outline how the internal rating process be

applied to various transactions and facilities.

Credit CultureA definition of acceptable credit risk that is known & applied

throughout the organization, such that the risks taken

reflect stated risk appetite.

Rating ModelsThe models should provide the basis of the internal rating

procedure to ensure consistency of approach to the setting

of ratings.

PeopleHowever, good the model sounds, it is very crucial that the

banks employ high-quality personnel to handle the models.


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Banks Credit Rating

Credit ReviewAnalysis & audit of previous decisions on the credit

portfolio must be carried out.

Credit ForumThe setting of internal rating methodology for particular

portfolio segments is also vital, if the rating is to be effective.

Delegated AuthoritiesManagement must ensure that the most appropriate level

of credit sign-off approves transactions, or facilities,

culminating in the credit committee.


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Banks Credit Rating

The factors considered in the rating of banks or financial

Institutions are as follows:

Industry Risk Financial Risk

Structure Funding & LiquidityOwnership profile Capitalization

Customer base Earnings

RegulationMarket position

Degree of diversification

Management style & strategies

Standards of accounting used

Perceived Economic Risk Risk Management

Credit Risk Strategy Market Risk

Market/Structural Risk Credit Risk

Trading Risk Financial Flexibility


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Banks Credit Rating

Industry RiskStructure

Depth of publicly traded capital markets and the trends inthis area,

Basic structure of the banking system,

(e.g. number & sizes of inst i tut ion s)

Proportion of finance in the economy that is intermediated

through banks, non-bank competitors in the market & the

extent of that they pose a serious challenge to the banks,

Dynamics of inter and intra-industry competition,

(e.g. expec tation of change, degree of dis- intermediation, & barr iersto entry).


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Banks Credit Rating

Industry RiskStructure

Strategic investments in industrial companies & types ofbenefits/risks posed by holding these investments,

Is there any consolidation trend in the banking system?,

Degree of transparency, standards of accounting, reporting

systems, auditing standards applied, and

Reliability/strength of the countrys legal system & judiciary

procedures.


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Banks Credit Rating

Industry RiskOwnership Profile

Are the banks owned by corporate groups or individuals?

The advantages/disadvantages emerging from the

relationship.

Level of government-owned banks within the banking system

The extent to which state-owned banks perform any special

public sector role or compete on equal footing with the

private sector banks (i .e. any s pecial pr ivi leges? )

Extent which government involvement in the banking system

affects the sectors competitiveness.


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Banks Credit Rating

Industry RiskCustomer Base

Existing commercial relationship prevailing between thebanks & corporate customers,

Financial strength of the personal sector & the level of social

benefits offered in the operating jurisdiction, and

Price sensitivity and the level of sophistication of the

customer base.

A very usefu l p iece of in format ion to assess the scope of bankingbus iness f lour is hing , stagnat ing, or decl in ing .


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Banks Credit Rating

Industry RiskRegulation

Is there any deposit insurance facilities for banks?,

Process of de-regulation, areas within the financial system

that have already been de-regulated,Any addit ion al measu res expected, t ime frame for de-regulat ion process

& expected impact on various econom ic sectors?

What sort of legislations are observed by the banks?(e.g. state, nation al, international s tandards)

Governments regulatory philosophy in relation to the needof continuous intervention within the banking system & the

corporate sector,

Regulatory structure in place (e.g. level/quali ty of supervis ion etc)


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Banks Credit Rating

Industry RiskMarket Position

Degree of vulnerability of the market position,

Banks market shares in key business sectors & size of

those markets,

Tangible advantages from the market position,

(e.g. fund ing so urces, qual i ty of bus iness, pr icing sty le)

What are the trends emerging from the existing market?


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Banks Credit Rating

Industry RiskDegree of Diversification

To what extent is the banks business represented bydiversification strategy?

What are the geographic spread of the banks customers

base?

Consideration of the banks segmental diversity,

(e.g. business uni ts, custom er segments, & produ cts/serv ices).

Are the banks internationally represented throughdiversification?(e.g. percentage of revenue local, internat ional & bo th).


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Banks Credit Rating

Industry Risk (Management Style & Strategies)Risk level of strategic direction,

Growth prospects,(e.g. internal vs external grow th, merger & acquis i t ions, f inanc ing pol icy

and pract ices).

Quality of forward planning (e.g. financial & st rategic issues),

Credibility of management style (e.g. track reco rd, pastPerformance),

Corporate independence of the banks management(e.g. political interferences, shareholders pressure on strategic decisions

Organizat ional stru ctu re (e.g centr al ized or decent ral ized)

Quality & depth of management (e.g. dependence on key personne


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Banks Credit Rating

Industry Risk (Accounting Standards Used)Accounting for past due loans, restructured loans, other

problem loans, foreclosures, commitments, contingencies.

Valuation of other balance-sheet items, (e.g. real es tates,Foreclosed assets, der ivat ives, & o ther intangib les).

Revenue recognition policies, including interest accrual onproblem loans & scurrilities, fee income, income from the

securitization proceeds.

Expense recognition, impairment charges, pension expensedeferred taxes.

Use of expense reserves (inc lud ing restructur ing cos ts), their

materiality & movements.


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Banks Credit Rating

Industry Risk (Accounting Standards Used)Accounting principles used (e.g. IFRS or US GAAP)

Use of special purpose vehicles, joint ventures, non-financial

subsidiaries, other subsidiaries.

Securities valuation policies (e.g. book values vs market values).

Overall quality of accounting for earnings, considering the

Impact of special and non-recurring items, accounting

changes, & other smoothing techniques.

Adequacy of problem asset coverage, including provisioning

policy & valuations.

Off-balance sheet items (e.g. pensio n, retirement benefits ,

con t ingent l iabi l i t ies, guarantees, performance bonds)


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Banks Credit Rating

Perceived Economic RiskThe countrys political stability (e.g. has the country a s table gov t?)

Structural problems facing the country (a number of und er-Developed countr ies face such problems namely in Afr ica and South

Amer ica).

Structural problems can be categorized as:* current account deficits,* high inflation,

* high unemployment rate,

* lack of competitiveness, and

* fiscal deficits

From rating viewpoint these problems must be corrected

with measures so as to improve the countrys image in the

international community.


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Banks Credit Rating

Perceived Economic RiskThe size of the economy is equally vitalsmall island states

economies has great difficulties with the management ofthe economy (i .e. strength s vs vu lnerabi l i ty).

This due to their size-effect, where it is difficult to achieve

economies of scale in mass production.

The small island states are very vulnerable to external

shocks due to its integration with the rest of the industrial

world.

The business cycle (e.g. vo lati l i ty in GDP, volati l i ty in asset p rices,bankruptc ies, and other changes in the econ omy).

Constraints on the authorities to take appropriate economic

measures in good time.


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Banks Credit Rating

Perceived Economic RiskThe growth prospects for the economy and the rate of credit

and monetary growth relative to the economic growth rate.

The openness of the economy with the rest of the world.

(e.g. regional, intra-regio nal, and international agreements).

Dynamics of savings and investment in the economy.(e.g. pol icy on savings culture, and prom otion o f foreign directinvestmentsFDI).

Structure and overall financial strength of the corporate &personal sectors.

Does the Government allow the private sector to play a key

role in the economyas engine of growth?


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Banks Credit Rating

Credit RiskStructure of the balance sheet of the banks including the

relative proportion in different low-credit risk assets(e.g. govt. bills. Inter-bank deposits) compared with higher-

risk assets (e.g. loans, equities).

Credit portfolio split into : loan type, maturity, collateral,

customer base, economic sector, size, currency & country.

Level of fixed income securities (e.g. type, largest positions,

market value, & maturity structure).

Loan loss reserves, (e.g. type, general & specif ic, reserves againston and off-balance sheet exposures, l iquidat ion p rovis ions , charge-off

for th e past 5 years, and recover ies reco rd).


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Banks Credit Rating

Credit RiskConcentration of credit risk (e.g. large exposures to specif icIndu str ies, markets, indiv idual borrowers, or sp ecif ic loan types).

Equity securities (e.g. econom ic sector, largest exposures,Propor t ion of inv estment por t fo l io relat ing to p revious underwr i t ing

Posit ion s, investment strategy, boo k value vs market value).

Reserves policy & adequacy.

Problem loans (e.g. Large credit exposu res, levels in & changes inNon-performing assets, past due loans, restruc tured loans, and

Expected future trends w ith other problem assets).


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Banks Credit Rating

Trading RiskClear description of the organization structure.

Breakdown of products/services by currency, credit quality,

volume, and maturity profile.

Future product & market expansion plans.

Identification of the market strengths & weaknesses, and

level of interest in position taking.

Trading strategy on group basis & by individual products.

Review of historic trading records (e.g. prod uc ts, market, sizeof posi t ion s, vo lat i l i ty of net revenues, & prof i tabi l i ty).

Liquidity of the market , which banks operate.


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Banks Credit Rating

Financial Risk (Earnings)Operating expenses : level & trend of overhead relative to the

banks business mix and distribution network.

Quality of the accounting practices in place.

Net operating income analysis (level & trend).

Loan loss provision (e.g. curr ent level, past v olati l i ty, & abil i ty toabsorb fu ture requ irements).

Net interest income: margin trends & ability to maintain

volume.

Non-interest income: diversity & sustainability of other

income sources & growth potential.


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Banks Credit Rating

Financial Risk (Earnings)Impact of extra-ordinary gains, and/or, charges.

Tax position (e.g. histor ic al and future use of net operat ing lo ss ,other tax planning scenar ios).

Impact of inflation on earnings, return on equity vs the

reporting periods of inflation rate.

Earnings outlook or projections (e.g. budget vs actual , project ionfor the medium to long -term).


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Banks Credit Rating

Risk Management (Credit Risk)Problem assets (e.g. respon sibi l i ty to fo l low u p, col lect ion s,foreclosures, col laterals, style of credit management & monito r ing).

Monitoring of credit exposures (e.g. control of d isbu rsements ,review func t ion, internal rat ing s ystem , role of audit department, problem

of exposu res).

Underwriting policiesthat is, the approval process for

Different types of products/ services, customer groups.(e.g. f ixed in com e secur i t ies, investm ent or trading equit ies, mo rtgage

loans, consumer loans , corp orate loans, delegated lend ing powers,

co l lateral valuat ion, and monito r ing).

Essentially, it is very important for management to have a

clear cut guideline or policy on the handling of credit risk

because it can have serious financial consequences for the

banks.


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Banks Credit Rating

Risk Management (Market Risk)A general understanding of market risk by the senior

mangers or executives and the importance of sound riskmanagement architecture.

Strategy regarding intentional position taking, limits,

authorities required for the breaching limits.

How traders and desk executives monitor positions & how

the system interacts with the overall risk management

structure in place.

Dynamics of the Asset & Liability Management Committee

(ALM) towards the different types of risk.

Hedging strategies (if any), and management view on

hedging transactions.


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Banks Credit Rating

Risk Management (Market Risk)Audit function (e.g. both internal & external auditors)

Accounting policies (i .e. consis tency vs change)

Back office operations (e.g. valuat ion pos it ions , organizat ion,disaster recov ery procedures & pol ic ies).

Stress testing of the loan portfolio & other earning assets.

Impact of the information technology system on the entire

operations.(e.g. adequacy of h ardware & so ftware, virus protect ion software,

safeguards against in trusio n, theft , and d amage, disaster recovery

plan, insu rance protect ion).

These criteria are applied by Standard & Poors.


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Banks Credit Rating

The ratios are categorized into FOUR types:

(a) Profitability,

(b) Liquidity,

(c) Capital,

(d) Asset Quality.

Whereas, banks are assessed using CAMEL system

for inter-bank comparison.

CAMEL represents Capital, Asset, Management,

Earnings, & Liquidity.It is also the current practice to include sensitivity analysis


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Banks Credit Rating

Profitability Revenue/Average Assets

Net Interest Income/Average Assets

Non-interest Income/Average Assets Non-interest expenses/Average Assets

Net operating Income before Loan Loss Provision/ Average Assets

Net operating income after Loan Loss Provision/Average Assets

Loan Loss Provision/Average Assets

Net Income/Average Assets (ROA) Revenue/Average risk-adjusted Assets

Net Income/Average risk-adjusted Assets

Net Interest Income/Total Revenue

Non-interest Income/Total Revenue

Non-interest Expense/Total Revenue

Net Operating Income before Loan Loss Provision/Total Revenue

Net Operating Income after Loan Loss Provision/Total Revenue

Pre-tax Profit/Total Revenue

Net Income/Total Revenue

Net Interest Income/Average Earning Assets


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Banks Credit Rating

Liquidity

Total Deposits/Total Liabilities

Loans/Customer (core) Deposits

Loans/Total Assets

Net inter-bank Deposits/Total Liabilities


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Banks Credit Rating

Capital

Adjusted Equity Capital/Total Assets

Adjusted Equity Capital/Total Risk Assets

Adjusted Equity Capital/Total Loans

Double Leverage Equity Capital + Loan Loss Reserves/Total Loans

Tier 1 Capital/Regulatory Risk Assets

Adjusted Total Equity Capital/Total Assets

Adjusted Total Equity Capital/Regulatory Risk Assets

Dividend Pay Out Ratio


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Banks Credit Rating

Asset Quality

Loan Loss Provision/Average Loans

Net Charge-offs/Average Loans

Loan Loss Reserve/Gross Loans

Loan Loss Reserve/Risk Assets

Non-performing Assets (NPA)/Total Loans

Net NPA/Net Loans

Loan Loss Reserve/Non-performing Assets


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Banks Credit Rating

Conclusion made by S P suggests that the banking sector needs to

further improve its risk management structure to cope with an

increasingly dynamic operating environment.

Quote: Asia-Pacif ic Bank ing Outlo ok 2005S&P Report


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Banks Credit Rating

Positive Factors Identified

1. Enhanced Transparency

Regulator is committed to enhance the systems transparency &bring disclosure standards closer to international norms.

It is tightening up definitions of non-performing loans and plan

a much stricter loan provision requirementseffective from July 05

2. Improvement in Asset QualityNon-performing loans have been reduced from 15% in 2001 to 8%

as at June 2004.

It is expected that the banking sectors impaired asset ratio is likely

to drop within a range of 5% to 7% .

3. Regulatory-driven Takeovers & Consolidations

The first regulatory-driven takeover of a distressed bank through

Government auction system took place in 2004.

The regulator wants to use this strategy for other insolvent banks

in future.


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Banks Credit Rating

Negative Factors Identified

1. Severe CompetitionTaiwans banking system is high fragmented, while its product menu

are homogeneous.

There is intense competition for several key business products.

2. Overdependence on Interest IncomeThe banks rely too much on interest income, and non-interest revenue

is a small proportion of total revenue.

3. Government Privatization Initiative

More privatization of some govt-linked banks will not benefit fromthe Government supportwhich previously improved the ratings.


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Banks Credit Rating

Negative Factors Identified

4. Inadequate Loan Loss Provisions

Average provision coverage ration increased to 23% (end o f 2003) ascompared to 14% in 2001. (est imated loss accoun t for 50%)

In spite of the banks developing their own provisioning practices, the

overall provisioning exercise is still considered inadequate.

5. Underdeveloped Risk Management Structure

Only a few banks have developed rather sophisticated risk

management structure.

The sectors overall risk management capacity is still in its infancystage.

Some banks remain over-reliant on the regulatory guidelines to

manage their risks profile.

Source: S&P Outlook 2005


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Banks Credit Rating

I wish you all,

good luckin your studies.


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Banks Credit Rating


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banks credit rating

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