METHODOLOGY FOR RATING BANKS
CAREs ratings are an opinion on the relative ability and willingness of an issuer to make timely payments on the
specific debt obligations over the life of the instrument. CARE has developed a comprehensive methodology for credit
rating of debt instruments issued by banks.
Some of the factors considered in CAREs rating analysis are described below:
QUANTITATIVE FACTORS
The starting point in reaching a rating decision is a detailed review of key measures of financial performance and
stability:
Capital Adequacy
Capital Adequacy is a measure of the degree to which the banks capital is available to absorb possible losses. CARE
examines the conformity of the bank to the RBI guidelines on capital adequacy ratio. The extent of possible Government
support to subscribe to the capital of weak banks to improve the capital adequacy ratio is examined.
Asset Quality
Asset Quality review assesses the quality of the banks overall loan portfolio and includes a sector by sector analysis
of the loan and guarantee portfolio, as well as inter-bank exposures. The historical recovery rate of annual demands of
principal and interest and the banks experience of loan losses and write-off/provisions are studied. The percentage of
assets classified into standard, substandard, doubtful or loss is examined closely. The portfolio diversification and
exposure to troubled industries/areas is evaluated to determine the extent of potential losses. In addition, the banks
own credit risk norms are examined.
Funding and leverage
The funding mix determines the leverage and the cost of capital. One of CAREs principal aims in bank analysis is to
assess the institutions ability to finance itself in times of stress. CARE examines the composition of deposits in terms
of short term or long term, domestic or foreign currency and also the composition of currencies. The volatility, growth
and shift in the composition of the funding pattern is also studied. Overall gearing, interest coverage and their trends
are taken as measures of financial risk arising as a result of funding decision.
Liquidity
Liquidity is often the proximate cause of bank failure, while, strong liquidity can help even an otherwise weak institution
to remain adequately funded during difficult times. CARE determines the maximum stress which the bank is likely to
face and evaluates the internal and external sources available to meet this. Factors examined are the credit deposit
ratio, the maturity matching of assets and liabilities, proportion of liquid assets to total assets and the degree to which
core assets that are illiquid are funded by core liabilities. The short term external funding sources in the form of
refinance facilities from RBI and the inter-bank borrowing limits available are considered. The banks CRR and SLR
investments are important sources of reserve liquidity.
Earnings quality
Earnings quality reviews cover the performance and risk assessment of each business area; the loan portfolio,
guarantees and forex & treasury operations, and non fund based activities such as merchant banking and advisory
services. CARE focuses on the strength of each major business and its earning prospects. The main indicators used to
measure profitability are return on assets, spreads, the expense ratios and the earnings growth rate.
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Evaluation of quantitative factors is done, not only of the absolute numbers and ratios, but their volatility and trends as
well. The attempt is to determine core, recurring measures of performance. CARE also examines how the banks
performance on each of the above discussed parameters is, compared to its peers. Detailed inter-firm analysis is done
to determine the relative strengths and weaknesses of the bank in its present operating environment and any impact
on it, in future.
QUALITATIVE FACTORS
Some of the qualitative factors that are deemed critical in the rating process are:
Ownership
An assessment of ownership pattern and shareholder support in a crisis is significant. In case of public sector banks,
the willingness of the government to support the bank is an important consideration.
Management quality
The composition of the board, frequency of change of CEO and the organisational structure of the bank are considered.
The banks strategic objectives and initiatives in the context of resources available, its ability to identify opportunities
and track record in managing stress situations are taken as indicators of managerial competence. The managements
response to the deregulation in the financial sector in terms of setting up specialised subsidiaries and branches to
cater to different business segments is studied.
CARE analyses the banks budgeting process and cost control in terms of their effectiveness. The adequacy of the
information systems used by the management is evaluated in terms of quality and timeliness of the information made
available to bank managers. The extent of frauds committed in the bank is taken as an indication of the imperfections
of the control systems. CARE focuses on the modern banking practices and systems, degree of computerisation,
capabilities of senior management, personnel policies and extent of delegation of powers. The track record of labour
relations is also examined.
Risk Management
Credit risk management is evaluated through the appraisal, monitoring and recovery systems and the internal prudential
lending norms of the bank. The banks balance sheet is examined from the perspective of interest rate sensitivity and
foreign exchange rate risk. Interest rate risk arises due to differing maturity of assets and liabilities and mismatch
between the floating and fixed rate assets and liabilities. CARE also assesses the extent to which the bank has assets
denominated in one currency with liabilities denominated in another currency. The derivatives and other risk management
products used in the past and implication of these deals is also analysed.
Compliance with statutory requirements
CARE examines the track record of the bank in complying with SLR/CRR and priority sector lending norms as specified
by the RBI.
Accounting Quality
Rating relies heavily on audited data. Policies for income recognition, provisioning and valuation of investments are
examined. Suitable adjustments to reported figures are made for consistency of evaluation and meaningful interpretation.
Size and Market Presence
The fund base and branch network of the bank are taken as important indicators of strength. In a fast changing environment,
a bigger bank can meet the competitive challenges from other financial intermediaries due to its economies of scale and
wider reach. Also if the bank represents a substantial percentage of the banking sector, its failure would cause severe
disruptions for the country as a whole and it is thus likely to obtain government support in times of distress.
All relevant quantitative and qualitative factors are considered together, as relative weakness in one area of the banks
performance may be more than adequately compensated for by strengths elsewhere. However, the weights assigned
to the factors are different for short term ratings and long term ratings. The intention of long term ratings is to look over
a business cycle and not adjust ratings frequently for what appear to be short term performance aberrations. The
quality of the management and the competitiveness of the bank are of greater importance in long term rating decisions.
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The rating process is ultimately a search for the fundamentals and the probabilities for change in the fundamentals. The
assessment of management quality, the banks operating environment and its role in the nations financial system are
used to interpret current data and to forecast how well the bank is positioned in the future. The final rating decision is
made by the Rating Committee after a thorough analysis of the banks position over the term of the instrument with
regard to business fundamentals.
For Further details please contact at :
CREDIT ANALYSIS & RESEARCH LIMITED
Kalpataru Point, 2nd Floor, Kamani Marg, Sion (East), Mumbai - 400 022 INDIA.
Tel. : 56602871-75 / 2402 4541/3 Fax : 56602876 E-mail :
[email protected]Disclaimer
CAREs ratings are opinions on credit quality and are not recommendations to buy, sell or hold any security.
CARE has based its ratings on information obtained from sources believed by it to be accurate and reliable.
CARE does not, however, guarantee the accuracy, adequacy or completeness of any information and is not
responsible for any errors or omissions or for the results obtained from the use of such information. Most issuers
of securities rated by CARE have paid a credit rating fee, based on the amount and type of securities issued.
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