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  1. Welcome to this Presentation Banks Credit Rating Presented by : Dr. Peter Larose

  2. Sit Back, Relax, Enjoy, The Presentation Banks Credit Rating

  3. Focus of this Presentation Focus of this Presentation • What is credit rating? • Why the need for a credit rating? • Who are the credit rating agencies? • Factors influencing change in banks rating, • Rating definitions used by Standard & Poor’s (S&P), • S&P criteria for rating, • Where do the Taiwanese banks fit? • The role of rating agencies, • Use of external rating scales, • Internal ratings, • Banks rating methodology, • Financial ratios used by S&P, • Taiwan banking outlook, and • What have we learnt?

  4. What is 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 company’s credit worthiness against other companies operating in similar market or industry internationally. 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. Banks Credit Rating

  5. Why the Need for a Credit Rating? • 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 a • significant 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, Banks Credit Rating

  6. Why the Need for a Credit Rating? (e) It is considered part of the Corporate Governance principles – for 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 company’s or bank’s financial soundness and stability, (g) Analysts and investors can compare a company or bank’s 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. Banks Credit Rating

  7. Who Are the Credit Rating Agencies? There are at least 74 Credit Rating Agencies around the world. Just to name a few: Banks Credit Rating

  8. Factors Influencing Change in Banks Rating • Higher Rating • * Ability to generate sound, stable earnings and capital over • time (inclusive of both the regulatory and economic capital) • The prevailing political stability in the country, where the • banks are operating (upgrade of the BFSR by S&P focus on • preferential capital, and subordinated debts). • Application of conservative risk metrics (e.g. credit, interest • rate, foreign exchange rate), and • Consistent earnings – a fundamental underpinning factor • for any rating exercise. Banks Credit Rating

  9. Factors Influencing Change in Banks Rating • Lower Rating • Major legislative changes that affect the banks in the • operating 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. Banks Credit Rating

  10. Ratings Definitions Used by Standard & Poor’s • The rating services use a 9-point rating scale based on the • following symbols: • “A” – has a Very Strong fundamental strength compared • with that of its global peers. • NB: It is the highest BFSR assigned by Standard & Poor’s • 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 Banks Credit Rating

  11. Ratings Definitions Used by Standard & Poor’s 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 & Poor’s. Banks Credit Rating

  12. S & P Criteria for Rating BSFR represent an S&P opinion of a bank’s fundamental strength, or more specifically, what has 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 Banks Credit Rating

  13. S & P Criteria for Rating • S&P does consider the following factors when • assessing a bank’s 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 risk • model. Banks Credit Rating

  14. S & P Criteria for Rating 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 Effects • Change by the Government • Regulator changes: • tax regime, • lending requirements, & • other regulations. • Indirect Effects • Decline in value of bonds, • Adverse change in external balance of payment (BOP), • Increase credit leverage, • Increase money-market volatility. Banks Credit Rating

  15. S & P Criteria for Rating 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. Banks Credit Rating

  16. Where Do the Taiwanese Banks Fit? 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 & Poor’s. The research takes into consideration the level of economic risk vs the business risk. Banks Credit Rating

  17. Economic & Industry Risk in Asia-Pacific Banking Systems ECONOMIC RISK INDUSTRY RISK Source: Standard & Poor’s : Asia-Pacific Banking Outlook 2005 Banks Credit Rating

  18. The Role of Rating Agenices 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 external agencies. 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. Banks Credit Rating

  19. The Role of Rating Agenices 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. Banks Credit Rating

  20. Use of External Rating Scales • The factors that allow banks to continue to promote the use • Of the rating agencies scales are as follows: • Publicly Available Data Set • Moody’s & Standard and Poor’s 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. Banks Credit Rating

  21. (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. Banks Credit Rating

  22. Internal Ratings • 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: • Credit policy applied, (e) Risk Review, • Credit culture, (f) Credit Forum, and • Rating models, (g) Delegated Authorities. • People, Banks Credit Rating

  23. Credit Policy Applied This should outline how the internal rating process be applied to various transactions and facilities. Credit Culture A definition of acceptable credit risk that is known & applied throughout the organization, such that the risks taken reflect stated risk appetite. Rating Models The models should provide the basis of the internal rating procedure to ensure consistency of approach to the setting of ratings. People However, good the model sounds, it is very crucial that the banks employ high-quality personnel to handle the models. Banks Credit Rating

  24. Credit Review Analysis & audit of previous decisions on the credit portfolio must be carried out. Credit Forum The setting of internal rating methodology for particular portfolio segments is also vital, if the rating is to be effective. Delegated Authorities Management must ensure that the most appropriate level of credit sign-off approves transactions, or facilities, culminating in the credit committee. Banks Credit Rating

  25. Banks Rating Methodology • The factors considered in the rating of banks or financial • Institutions are as follows: Industry Risk Financial Risk • Structure Funding & Liquidity • Ownership profile Capitalization • Customer base Earnings • Regulation • Market 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 Banks Credit Rating

  26. Rating Procedures for Banks Industry Risk Structure Depth of publicly traded capital markets and the trends in this area, Basic structure of the banking system, (e.g. number & sizes of institutions) 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. expectation of change, degree of dis-intermediation, & barriers to entry). Banks Credit Rating

  27. Rating Procedures for Banks Industry Risk Structure Strategic investments in industrial companies & types of benefits/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 country’s legal system & judiciary procedures. Banks Credit Rating

  28. Rating Procedures for Banks Industry Risk Ownership 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 special privileges?) Extent which government involvement in the banking system affects the sector’s competitiveness. Banks Credit Rating

  29. Rating Procedures for Banks Industry Risk Customer Base Existing commercial relationship prevailing between the banks & 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 useful piece of information to assess the scope of banking business flourishing, stagnating, or declining. Banks Credit Rating

  30. Rating Procedures for Banks Industry Risk Regulation Is there any deposit insurance facilities for banks?, Process of de-regulation, areas within the financial system that have already been de-regulated, Any additional measures expected, time frame for de-regulation process & expected impact on various economic sectors? What sort of legislations are observed by the banks? (e.g. state, national, international standards) Government’s regulatory philosophy in relation to the need of continuous intervention within the banking system & the corporate sector, Regulatory structure in place (e.g. level/quality of supervision etc) Banks Credit Rating

  31. Rating Procedures for Banks Industry Risk Market 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. funding sources, quality of business, pricing style) What are the trends emerging from the existing market? Banks Credit Rating

  32. Rating Procedures for Banks Industry Risk Degree of Diversification To what extent is the banks’ business represented by diversification strategy? What are the geographic spread of the bank’s customers base? Consideration of the banks’ segmental diversity, (e.g. business units, customer segments, & products/services). Are the banks’ internationally represented through diversification? (e.g. percentage of revenue local, international & both). Banks Credit Rating

  33. Rating Procedures for Banks Industry Risk (Management Style & Strategies) Risk level of strategic direction, Growth prospects, (e.g. internal vs external growth, merger & acquisitions, financing policy and practices). Quality of forward planning (e.g. financial & strategic issues), Credibility of management style (e.g. track record, past Performance), Corporate independence of the banks’ management (e.g. political interferences, shareholders’ pressure on strategic decisions Organizational structure (e.g centralized or decentralized) Quality & depth of management (e.g. dependence on key personnel Banks Credit Rating

  34. Rating Procedures for Banks 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 estates, Foreclosed assets, derivatives, & other intangibles). Revenue recognition policies, including interest accrual on problem loans & scurrilities, fee income, income from the securitization proceeds. Expense recognition, impairment charges, pension expense deferred taxes. Use of expense reserves (including restructuring costs), their materiality & movements. Banks Credit Rating

  35. Rating Procedures for Banks 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. pension, retirement benefits, contingent liabilities, guarantees, performance bonds) Banks Credit Rating

  36. Rating Procedures for Banks Perceived Economic Risk The country’s political stability (e.g. has the country a stable govt?) Structural problems facing the country (a number of under- Developed countries face such problems – namely in Africa and South America). 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 country’s image in the international community. Banks Credit Rating

  37. Rating Procedures for Banks Perceived Economic Risk The size of the economy is equally vital – small island states economies has great difficulties with the management of the economy (i.e. strengths vs vulnerability). 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. volatility in GDP, volatility in asset prices, bankruptcies, and other changes in the economy). Constraints on the authorities to take appropriate economic measures in good time. Banks Credit Rating

  38. Rating Procedures for Banks Perceived Economic Risk The 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-regional, and international agreements). Dynamics of savings and investment in the economy. (e.g. policy on savings culture, and promotion of foreign direct investments –FDI). Structure and overall financial strength of the corporate & personal sectors. Does the Government allow the private sector to play a key role in the economy – as engine of growth? Banks Credit Rating

  39. Rating Procedures for Banks Credit Risk Structure 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 & specific, reserves against on and off-balance sheet exposures, liquidation provisions, charge-off for the past 5 years, and recoveries record). Banks Credit Rating

  40. Rating Procedures for Banks Credit Risk Concentration of credit risk (e.g. large exposures to specific Industries, markets, individual borrowers, or specific loan types). Equity securities (e.g. economic sector, largest exposures, Proportion of investment portfolio relating to previous underwriting Positions, investment strategy, book value vs market value). Reserves policy & adequacy. Problem loans (e.g. Large credit exposures, levels in & changes in Non-performing assets, past due loans, restructured loans, and Expected future trends with other problem assets). Banks Credit Rating

  41. Rating Procedures for Banks Market & Structural Risk The role and objectives of the Ministry of Finance towards risk appetite. Reasons for structural risk (e.g. legal restrictions, regulatory requirements, limitations on the local funding or hedging markets, or position taking). Use of non-cash market instruments (e.g. futures, forwards, Swaps), Levels of interest rate, foreign exchange, and equity participation in the balance sheet. Management attitude towards the Asset/Liability Management (ALM) and the composition of the balance sheet. Banks Credit Rating

  42. Rating Procedures for Banks Trading Risk Clear 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. products, market, size of positions, volatility of net revenues, & profitability). Liquidity of the market , which banks operate. Banks Credit Rating

  43. Rating Procedures for Banks Financial Risk (Funding & Liquidity) The banks’ philosophy towards the liquidity management, and plan. Flow of funds (e.g. deposit maturities, stability of funding, deposit flows). Composition of the bank’s funding (e.g. retail vs corporate, professional markets). Asset liquidity (e.g. pledged assets, long-term marketable securities, ability to securitize the loan portfolio, standby facility with the Central bank, inter-bank transactions). Diversity of funding (e.g. deposits in geographic areas, size, access to local capital and money market). Banks Credit Rating

  44. Rating Procedures for Banks Financial Risk (Capitalization) Banks’ capital position with respect to domestic capital & BIS requirements. Dividend pay out ratio – internal growth rate of capital. Ability to tap into external long-term capital. Absolute size of the banks’ capital base & ability to absorb extra-ordinary, unexpected losses. Capital composition structure (e.g. risk capital, preferred shares, perpetual debts, subordinated debts, minority interest, goodwill, revalued assets, unrealized capital gains, loan losses in excess of the target losses). BIS risk-weighted assets adjusted for high credit risk. Banks Credit Rating

  45. Rating Procedures for Banks 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. current level, past volatility, & ability to absorb future requirements). Net interest income: margin trends & ability to maintain volume. Non-interest income: diversity & sustainability of other income sources & growth potential. Banks Credit Rating

  46. Rating Procedures for Banks Financial Risk (Earnings) Impact of extra-ordinary gains, and/or, charges. Tax position (e.g. historical and future use of net operating loss, other tax planning scenarios). Impact of inflation on earnings, return on equity vs the reporting period’s of inflation rate. Earnings outlook or projections (e.g. budget vs actual, projection for the medium to long-term). Banks Credit Rating

  47. Rating Procedures for Banks Risk Management (Credit Risk) Problem assets (e.g. responsibility to follow up, collections, foreclosures, collaterals, style of credit management & monitoring). Monitoring of credit exposures (e.g. control of disbursements, review function, internal rating system, role of audit department, problem of exposures). Underwriting policies – that is, the approval process for Different types of products/ services, customer groups. (e.g. fixed income securities, investment or trading equities, mortgage loans, consumer loans, corporate loans, delegated lending powers, collateral valuation, and monitoring). 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. Banks Credit Rating

  48. Rating Procedures for Banks Risk Management (Market Risk) A general understanding of market risk by the senior mangers or executives and the importance of sound risk management 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. Banks Credit Rating

  49. Rating Procedures for Banks Risk Management (Market Risk) Audit function (e.g. both internal & external auditors) Accounting policies (i.e. consistency vs change) Back office operations (e.g. valuation positions, organization, disaster recovery procedures & policies). Stress testing of the loan portfolio & other earning assets. Impact of the information technology system on the entire operations. (e.g. adequacy of hardware & software, virus protection software, safeguards against intrusion, theft, and damage, disaster recovery plan, insurance protection). These criteria are applied by Standard & Poor’s. Banks Credit Rating

  50. Financial Ratios Used by S&P • 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 Banks Credit Rating