Rating Methodology Profile for Financial Institutions

THE CAMEL METHODOLOGY

The CAMEL methodology for bank credit analysis is well established and identifies five key factors for assessing the soundness of a bank. These factors are to be assessed both on an individual basis for the institution to be rated and in comparison with appropriate measures of performance for the financial institution’s previously defined peer group. The peer group should include banks in the country of the subject financial institution since they all operate under the same regulatory regime and prepare financial statements under the same accounting policy. The peer group may be extended beyond the country of the subject only to the extent that (i) differences in regulatory definitions that impact asset quality, capital adequacy, and liquidity ratios are taken into account and (ii) differences in financial accounting conventions are understood and factored in. Such performance comparisons should be made both retrospectively over the past three to five years (depending on the tenor and type of transaction being discussed) as well as prospectively based on projections to form a judgment on a bank’s credit quality.

Risk Factors Key Risk
The Regulatory Environment Restrictions on related party loans; definition of legal lending limits; guidelines on loan classifications, definition of loan impairment (non- performing loans or NPLs), provisioning, and capital adequacy (including definitions of Tier 1 and Tier 2 capital, definition of “capital” for purposes of calculating capital ratios, and risk weights for various asset classes). Overall quality of regulatory supervision.
Capital Adequacy Central Bank capital ratios Equity/Assets ratio Open loan exposure (if impaired loams are not fully provisioned)
Asset Quality Loan concentrations Impaired loans / total loans Adequacy of provisions
Management Senior management experience Business model and its execution Risk management policies and organization Governance
Earnings Contribution to earnings by various business groups; Interest margin analysis; Operating earnings analysis; return on average total assets and average total equity
Liquidity and Funding Deposit base (“core” vs “purchased” deposits) Deposit concentrations Capital market funding Liquid assets/total assets GAP analysis
THE REGULATORY ENVIRONMENT

In virtually all jurisdictions, banks come under regulatory oversight. However, since the quality of regulators and regulations is not uniform worldwide or even region-wide, a critical analytical issue is the quality of prudential regulation. The trend in many countries is to move toward stronger regulation. Regulators can and do define permissible and impermissible business activities. One such example is in the extension of credit to related parties (i.e. shareholders, directors, and management and their families) with the trend increasingly towards reining in such insider lending. Another area of interest is the definition of “legal lending limit”, the maximum size of any loan to an individual borrower or group of which the borrower is a part, generally expressed as a percentage of the bank’s capital. 8 The primary regulator may set standards for the amount of capital needed to protect the institution against credit, market, and (increasingly) operational risks. The regulatory regime may also define exactly what is considered as “capital” for purpose s of the calculation and may set rules for risk classifications of assets. Finally, the primary regulator may define risk classifications for loans and provision requirements tied to such classifications. In Brazil, for example, the Central Bank of Brazil (“BACEN”) sets forth a minim um level of capital, defines what is considered capital for purposes of the calculation, defines the risk weights assigned to assets, and also defines risk rating categories for loans, based on days past due with appropriate provision levels.

Comparing prudential regulation in Turkey to exogenous standards such as Basel guidelines or US regulation will be useful to illustrate where local regulation falls against a common standard.

ANALYSIS OF CAMEL FACTORS

Capital

The basic issue in assessing capital adequacy is whether the financial institution has -- in relative and in absolute terms – an adequate capita l base for its risk profile. There are two elements to consider: the actual amount of capital and the risks against which the capital provides protection. With respect to the amount of capital, it is important to consider the regulatory definition of capital since there are differences, for example, in the amount of Tier II capital which can be counted as capital eligible for purposes of calculating capital adequacy ratios. In taking a historical and a prospective view, the following are the relevant questions:

  • Support of principal shareholders

  • Capital raised in past five years as an indication of the ability and willingness of the institution to raise capital in the future

  • Capital increases planned/required in the near and medium-term

The risks against which capital adequacy is measured include credit risk, market risks, and operational risks. Modern quantitative methods may be used, such as value at (credit and market) risk. These measures can be used to stress test credit and market risks – e.g., a

8In Brazil, this limit is 25% of capital.

downgrading of the loan portfolio by “x” number of notches or a shift in the yield curve by “y” basis points. These stress tests help determine the sensitivity of the bank to different levels of credit and market risks. A bank that uses stress testing generally must have internal rating systems and detailed databases on probabilities of default and loss given default as well as pricing models for their market sensitive assets and liabilities. The adequacy of capital is also dependent on the risk weights applied by the regulators to different asset classes and the minimum capital they require. For example, in Brazil, given historic market volatility, the central bank standard is a minimum capital to risk assets ratio of 11% as compared with 8% recommended by Basel I.

Key Ratios

  • Equity/period end and average assets.

  • Central Bank capital ratios.

  • The open loan exposure ratio (impaired loans minus loan loss provisions to equity) will be used if the bank’s impaired loans under review are not fully provisioned.

Asset Quality

Deterioration in asset quality is a very common reason for problems both at individual banking institution and banking system levels. Macroeconomic crises can often adversely impact bank asset quality.

Asset quality can be assessed through such measures as the ratio of non-performing or impaired loans to total loans, risk concentrations (measured for example by the share of the top twenty loans in total loans), and the ratios of loan loss reserves not only to non-performing or impaired loans but also to total loans.

Regulatory definitions of loan status can affect asset quality measures and should be taken into account. There is an emerging consensus among regulators towards defining non-performing or impaired loans as those that are (for example) more than 90 days past due. It is also important to understand how impaired or non-performing loans are defined. If the amount of such loans is defined for regulatory purposes as the sum of overdue installments rather than the sum of remaining principal related to the impaired or non-performing loan, the regulatory definition would understate the magnitude of asset quality deterioration as measured under best international practice. In addition, regulatory guidelines for non-accrual status need to be taken into account, recognizing that the best international practice is that loans cease to accrue interest when they become impaired or non-performing. Absent such regulatory definition, one would need to rely on an individual bank’s definition of impairment which may not be tied to the number of days the loan is past due but rather the Bank’s judgment of whether full payment would eventually be made.

Regulators may also set loan loss reserve and provisioning requirements based on days loans are past due and may specify when a bank must fully provide for or write off a past due loan.

The emerging consensus is that loans must be fully provisioned when they are more than 180 days past due. There is a trend for banks to use internal ratings-based systems, to measure average portfolio ratings, expected probability of default under stress and loss given default. In Brazil, where provisions must be taken against new loans, such provisions are generally taken based on internal ratings. The efficacy of the internal ratings based systems should be assessed by (i) reviewing how such ratings are assigned and used internally by the bank and (ii) how such internal ratings are viewed, sanctioned or even defined by the regulatory authorities.

To assess asset quality, the following factors should be considered:

  • The bank’s loan approval and credit risk management processes

  • Growth of loan portfolio over last five years

  • Market focus i.e. middle market, large corporate credits, retail

  • Composition of commercial loan portfolio i.e. service businesses, manufacturing businesses, etc

  • Description of top twenty exposures (borrower and affiliated group) over the last five years measured in absolute terms and as a percentage of total loans and total equity

  • Level of non-performing loans as a percentage of total loans for last five years

  • Provisions required by regulators and those above regulatory requirements for last five years

  • Loan loss reserve reconciliation for last five years (beginning balance, additions, write-offs, write-backs, final balance)

  • Write off policy if different from that mandated by regulators

  • Annual write-offs for last five years

Key analytical ratios for asset quality are the following:

  • Impaired loans/total loans

  • Loan loss reserve/total loans

  • Loan loss reserve/impaired loans

  • Asset concentration -20 largest borrowers as a percentage of total loans and equity

  • Largest single exposure as a percentage of total loans and equity

The asset quality analysis should also go beyond the loan portfolio to consider the quality of securities in the financial institution’s investment portfolio. Concentrations in low rated or unrated securities, accounting practices on the valuation of those securities and extent of credit and market risk analysis (e.g., value at risk analysis and limits) and related risk management policies and procedures at the institution should be assessed.

Management

Traditionally, there are two basic issues in an evaluation of management. First, does the bank have a good and successful market strategy? Has the management correctly assessed its strengths, weaknesses, risks and opportunities to develop a viable and successful business model? Second, how successful is the bank in implementing its strategy on a prudent and a profitable basis? Over time, management assessment has expanded to include measures of corporate governance: related party activities, quality and independence of the Board of Directors, effectiveness of their oversight functions, independence and quality of senior management, relationship between Board members and controlling shareholders, compliance with regulations on anti-money laundering and fraud, compliance with regulations on information disclosure, quality of accounting (e.g. whether accounts are qualified); involvement in litigation, etc. In addition, good corporate governance includes the adequacy of risk management policies and procedures covering credit risk, market risk and operational risk.

When a bank is family owned, the ability and willingness of the owners to support the institution must be considered. In addition, the extent to which executive and management functions have devolved to professional management as compared to the ownership group should be assessed. Finally, the topic of management succession needs to be considered.

Other factors are changes in auditors, regulatory agency comments, rating changes, changes in management, shareholding structures, financial controls and one-off transactions of significance. One also needs to consider the readiness with which the institution is able to provide information requested during due diligence visits as it is an indicator not only of the quality of internal management information systems but more importantly of the level of financial control within the institution.

Following are the key analytic elements for management assessment

  • Organizational structure including holding company

    • Description of banking and non-banking subsidiary companies

  • Business model

    • Growth or profitability

    • Organic growth or growth through acquisitions

    • Business focus and strategy

  • Management team and experience

    • Management biographies

    • Management committees

  • Relationship with bank regulators.

  • Risk management policies and organization

  • Governance structure, the functions of a Board of Directors or a similar body and its main committees.

  • Corporate governance policies and procedures including those to limit potential conflicts of interest and money laundering.

  • Quality of the technology and systems, redundancies, back-up and disaster recovery.

Earnings

The bottom line is whether the bank’s business model is profitable, based on a sensible strategy executed with prudent management controls that limit asset quality, funding and other risks. Dependence on revenues from each major business activity should be considered, along with the stability of and outlook for such revenue. Measures of earnings have remained largely unchanged over time and typically include but are not limited to gross revenue, net interest margin, net income, cost/income, return on assets, and return on equity, etc.

An example of the interdependence of the elements of the CAMEL methodology is the impact of asset quality on earnings. Should levels of non-performing loans rise, larger provisions are generally indicated and these provisions may dilute the impact of strong revenues. High or rising net interest income with high or rising levels of provisions necessitated by declining asset quality may indicate a risky and potentially unsustainable credit profile.

It is important to understand that numbers help tell a story and diagnose a problem. In advance or in the absence of on-site due diligence, such analysis can help determine where to focus more attention. After the meetings, ratio analysis helps test one’s analysis and ability to reach and defend rating decisions. Peer group comparisons can play an important role in putting financial ratios in a proper perspective. Ultimately bank credit analysis is a matter of judgment based on analysis and experience.

Accordingly, the following should be understood

The following are the key earnings measures

  • Contribution of individual business units to operating earnings

    • Proportion of earnings attributable to

      • traditional banking activities that generate net interest margins,

      • those generating potentially stable and recurring fee income, and

      • those from proprietary trading and other potentially speculative activities that might generate income streams that are less stable

    • Earnings from ancillary businesses, e.g., asset management, insurance, etc.

    • Changes over the last five years

  • Net interest margin trend (and fee income) for last five years

  • Analysis of cost structure and trend for last five years

  • Net interest margin (net interest income/average earning assets)

  • Fee income as percentage of total operating income

  • Trading income as a percentage of net operating income

  • Total operating costs/net operating income

  • Return on average total assets

  • Return on average total equity

Liquidity, Funding and Asset and Liability Management

The basic issues in assessing liquidity and funding risks are (i) the stability of the bank’s funding base for its lending activities, whether through deposits or wholesale sources of funds, and (ii) the degree of diversification of such funding and the reliability of the sources of funds. It is important to determine if the sources are retail or wholesale deposits and concentrations among such sources. Gaps between assets and liabilities should be analyzed by maturity buckets (measured on an absolute as well as on a re-pricing basis). Currency mismatches (if any) should also be considered, especially for banks active internationally. It is important to know whether the bank is a net borrower or placer of funds in the money market and how easy it is for it to access liquidity from other banks and the central bank.

A liquidity crunch is generally a symptom of problems at the bank or in the banking system or both. Liquidity facilities are helpful in mitigating a short-term credit squeeze, which could result from external shocks such elections or devaluation or a crisis with a particular bank. But if a bank has to turn to such facilities repeatedly – i.e., to draw on central bank facilities or stand by lines from larger banks – it is generally a weak bank with structural problems, e.g., a mismatch of its assets and liabilities or weak asset quality or an unstable deposit base, a poor business model or weak governance (e.g., with large exposures to related party lending in areas with asset quality problems).

Following are the key measurements of liquidity:

  • Interbank funding /total funding

  • Deposits/total funding

  • Deposit concentrations-20 largest depositors

  • Gap analysis (3 month liabilities less 3 month assets as a percentage of total equity, 6 month liabilities less 6 month assets as a percentage of total equity)

  • Loans/assets

  • Loans/deposits

  • Liquid assets/deposits and money market funding

  • Liquid assets to total assets