INSTITUTE FOR FINANCIAL MANAGEMENT AND RESEARCH

CREDIT RATING MODEL FOR BORROWERS

NAMAN SINGH PGDMB11/75

CREDIT RATING FOR BANKS What is credit rating? In order to evaluate the credit worthiness of financial institutions like banks, rating methodology is employed which finds out the chances of default. Ratings are calculated by rating agencies on the basis of qualitative or quantitative information about a company or government. Usually credit rating are not based on mathematical formulas, they are based on the judgement and experience in determining what public and private information should be used in deriving the rating of a particular institution. Credit ratings are used by an individual or by other institutions to determine the likelihood of repayment. Low rating implies that there is high risk of default. The ratings are determined on the basis of going concern rather than mere assessment of banks financial on a particular date. The key factors in the rating process are 1) Governance a) Ownership structure b) Management & Risk management c) Governance structure 2) Financial a) Asset quality b) Capital Adequacy c) Profitability d) liquidity

Other factors which contribute to the ratings are operating environment and regulatory environment. Operating environment of a bank is evaluated through deep analysis of economic condition like gross domestic product of respective country, growth/ decline in the saving and credit. Apart from economic condition, political system and legal system is considered because they play important role in assessing the asset quality of banks and efficiency of recovering the delinquent loan. Regulatory body plays important role it monitors the activity of the bank. We can call this body as backbone of banking industry. In India Reserve Bank of India plays a key role in regulating and supervising banking activities. Rating involves norms for evaluation of capital and other countercyclical methods for absorbing the risk. Due to recent changes in international standards of reporting, Basel III which will be in effect will force rating agencies to change the method of their rating financial institutions. When it comes to governance there are different kinds of banks in india e.g. public sector, private sector, co-operative banks and regional banks. While all public banks are supported by government there ratings are high but when it comes to private banks rating agencies look at the promoters and shareholders whether they can raise the money at the time of distress. Rating agencies also focus on the share of business in region of operation, participation in payment systems, Agencies also focus on the guarantees to depositors against default or insolvency. In case of governance structure, agencies consider the functional ans structural aspect of the board of directors and committees. For a bank to function independently its governance should be appropriate to the working of the bank with the interest of the depositors not compromised for other stakeholders such as lending to vulnerable sections. A good governance structure also ensures that the powers given to line managers at a bank are exercised in accordance with the established procedures and that these procedures conform to the broad policy guidelines and strategic objectives of the bank.

Management, Systems and Strategy and Risk Management Agencies give special emphasis on governance issues; quality of management; systems and policies; shareholder expectations; the strategy followed to manage these expectations and accounting quality, as these aspects form the foundation of a banks credit risk profile. The importance of these factors is even higher for a new bank or one with a shorter track record. Usually, a detailed discussion is held with the banks management to understand its business objectives, plans and strategies, views on past performance and outlook on the industry. Rating agencies also assesses the shareholders expectations and their impact on the credit profile of a bank. Some of the other points assessed are: Experience and commitment of the promoter/management to the line of business concerned Attitude of the management to risk taking and containment The banks risk management policies (credit risk, market and operational risk) The ability and willingness of the promoters to support the bank through measures such as capital infusion, if required is also checked. In addition, agencies also evaluate the quality, depth, timeliness and relevance of information available to the banks management. Our analysis of system adequacy encompasses the quality of the communications network; levels of computerisation and integration within the bank; systems for accounting control; management information for monitoring performance; business development and statutory reporting. Rating agencies lays considerable emphasis on the effectiveness of the banks risk management systems and systems for strategic planning. For accounting control aspects such as accounting quality, balancing of books, inter-branch and inter-bank reconciliation, They draw on sources such as the Long-form Audit Report and the RBI Inspection Report apart from reviewing the banks internal reports and controls.

Risk Management

A close evaluation of the risk management policies of the bank is conducted, as it provides an important guidance for the future liquidity, profitability, asset quality and capitalisation of the bank concerned. The risk management of the bank is evaluated for the following: Credit risk: The risk of loss resulting from the failure of a client or counterparty to meet its contractual obligations; this risk could arise from the credit book as well as the investment

book Market risk: the risk of loss resulting from changes in market variables, mostly emanating from investment portfolio, although credit book could also contribute to it. Operational risk: the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external causes The evaluation of a banks risk management focusses on its ability to assess, control / mitigate and disclose the aforesaid risks.

Financial Performance Financial performance analysis is one of the key parameters used to compare a banks performance over a period of time and across its peer group. Agencies conduct a detailed financial analysis of the banks being rated. The key parameters that are under the scanner include: Asset Quality Liquidity Profitability Capital Adequacy

Asset Quality

The asset quality of a bank is a reflection of its risk appetite; depth of its franchise and effectiveness of its management, strategy, systems and processes. Asset quality holds the potential to affect earnings (higher NPAs could dilute the yields and necessitate higher credit provisions) and capital (lower earnings could slow down the internal capital generation or in extreme situations (loss) could weaken the capital). The asset quality evaluation includes the loan book as well as the non-SLR portfolio of a bank. Capital Adequacy

Capital provides the second level of protection to debt holders (earnings being the first) and, therefore, its quality and adequacy (in relation to the embedded credit, market, and operational risk) is an important consideration for ratings. Profitability

The profitability of a bank is evaluated by analysing its interest spreads (yields minus cost of funds) and the likely trajectory of the same in the light of the changes in its operating environment, its liquidity position and its overall strategy.

PARAMETERS USED FOR DERIVING THE CREDIT RATING OF A BANK SOLVENCY RATIO PARAMETER Capital Adequacy ratio Loan Loss Coverage Ratio Interest Coverage ratio PROFITABILITY RATIO PARAMETER ROA ROE ASSET QUALITY PARAMETER Gross npa to gross advance Fresh NPA to liquid ratio 10 RISK WEIGHT 15 RISK WEIGHT 20 20 9 9 RISK WEIGHT 17

Measurement of Account quantity PARAMETER Transparency Related to statutory compliances and disclosures Conservative and consistency Auditors/ Inspectors observation Signifies how banks maintain their books Signifies feedback about the financial statements and other statutory complainces Contingent liability Signifies net worth of the bank OBJECTIVE FACTORS UNDER BUSINESS PARAMETERS 20 25 30 25 Risk weight

PARAMETERS Net interested income to average funds employed Average cost of funds

RISK WEIGHT 25

12

Overhead expense to total income Yields on advances Yields on interest Non- interest income to total income Growth in business

10

10

10

10

SUBJECTIVE FACTORS UNDER BUSINESS PARAMETERS PARAMETER RISK WEIGHT Product range/specialisation/innovation Brand name of the equity Promotional activity Edge in adoption of technology Under business parameter: Business parameters Objective factors Subjective factors Average score under business parameter OBJECTIVE FACTORS UNDER MANAGEMENT PARAMETER weightage 80 20 10 25 25 25 25

PARAMETERS Percentage increase in advances Increase in gross income Increase in net profit Increase in loss of funds

RISK WEIGHT 25

25

25 25

SUBJECTIVE FACTORS UNDER MANAGEMENT PARAMETERS PARAMETER Repayment rate to other financial institutions Performance of parental/group support Credibility Corporate governance Reputation in the market Quantity of management personnel Under management parameter Risk weights Objective factors Subjective factors 75 25 15 20 15 15 15 RISK WEIGHT 20

CONSOLIDATED CREDIT RISK RATING BROAD CATEGORY Financial Business Management 50 30 20 RISK RISK WEIGHT

RATING BASED ON THE CONSOLIDATED RATING Score(S) 95 86 S <95 77 S <86 69 S <77 61 S <69 53 S <61 rating AAA AA A BBB BB B

AAA rating indicates that institute is safe for lending , it can repay its debt and chances of default is very less. Reference: ICRA WEBSITE