The rating methodologies developed by Infomerics for evaluation of banks comprise of qualitative and quantitative factors, the details of which are described below. The Qualitative Factors that are found critical in the rating process are:
The scale of operations of a bank determines its capacity & ability to grow, while maintaining reasonable risk adjusted returns and sustenance of earnings with resilience. Hence, the strength of a bank in terms of scale of operations and market share with reference to competition are evaluated.
The Indian banking system consists of public sector banks, private sector banks, foreign banks, cooperative banks and regional rural banks. While comfort is drawn from the sovereign ownership of public sector banks, the credit view on other banks would depend on the ability of the bank to raise capital from promoters / other key shareholders, as and when required. Also viewed positively, is public sector bank with GOI shareholding well in excess of 51%, as it would have greater flexibility to raise capital by diluting GOI's shareholding.
Infomerics lays special emphasis on governance issues, quality of management, accounting quality, as these aspects form the foundation of a bank’s credit risk profile. The composition of the board, frequency of change of CEO/MD and the organisational structure of the bank are critically examined. The bank's strategic objectives and initiatives in the context of resources available, track record in managing stress situations is also evaluated. The extent of frauds committed in the bank is viewed as an indication of the inadequacy of the control system. The track record of labour relations is also looked into.
A careful 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 policy of the bank is evaluated for credit risk, market risk, operational risk, foreign currency risk and interest rate risk. Credit risk management is evaluated by examining the quality of appraisal, monitoring & recovery systems and the prudential lending norms of the bank. The bank's balance sheet is also examined from the perspective of interest rate sensitivity. The evaluation of a bank's risk management focusses on its ability to assess, control, mitigate and disclose the aforesaid risks.
A well regulated and supervised system is the backbone for credibility and stability of banks even when the operating environment is unfavourable. The track record of the bank in complying with regulatory compliances like SLR/CRR and priority sector lending norms as specified by the RBI are examined.
The rating is based on the audited financial data submitted by the issuer. Consistent & fair accounting policies are a pre-requisite for financial evaluation. Further, the RBI has also issued prudential norms for Banks specifying the accounting methods to be used for income recognition, provisioning for bad and doubtful advances and valuation of investments. In evaluating Bank's accounting quality, the review is made with regard to the Bank's accounting policies, notes to the accounts, and auditors' comments in detail.
SIZE AND MARKET PRESENCE
OWNERSHIP STRUCTURE AND GOVERNMENT SUPPORT
MANAGEMENT QUALITY
RISK MANAGEMENT
COMPLIANCE WITH STATUTORY REQUIREMENTS
ACCOUNTING QUALITY
Capital Adequacy is a measure of the bank’s ability to meet its obligations relative to its exposure to risk and also relates to the degree to which the bank's capital is available to absorb possible losses. It also indicates the ability of the bank to undertake additional business. The evaluation by Infomerics factors the conformity of the bank to the regulatory guidelines on capital adequacy ratio.Higher proportion of Tier I (core capital) in the overall capital is viewed favorably.The expected growth in the asset base and ability of the bank to generate capital through profits or by accessing capital markets, is also evaluated.
Resource base of the bank is analysed to assess the cost & composition. Deposits constitute core funding source of a bank. Higher proportion of low cost deposits in total deposits is viewed as positive and also examined is retail-wholesale deposit mix. Deposit growth rates and their rollover rates are also analysed. Ability of the bank to raise additional resources at competitive rates is also looked at.
Asset quality plays an important role in indicating the future financial performance of a bank. Asset quality holds the potential to impact 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 evaluation of asset quality begins with the examination of the bank's credit risk management framework. The overall asset quality is examined by evaluating the sector by sector loan and off-Balance Sheet exposures. The bank's experience of loan losses and write off/provisions are studied carefully. The percentage of assets classified into standard, sub-standard, doubtful or loss and the track record of recoveries of the bank are examined closely. The portfolio diversification and exposure to troubled industries/areas is evaluated to arrive at the level of weak assets. The extent of diversification is also an important indicator of a bank’s asset quality. In assessing diversification, the factors generally include loan mix, portfolio granularity, geographical diversification and borrower profile. To evaluate asset quality, Gross NPA, Net NPA and restructured assets/weak assets are examined. Restructured assets/weak assets in banks total exposure are closely examined to arrive at the potential NPAs of the bank.
Liquidity plays an important role in the stability of the bank. Lack of liquidity can lead to a bank’s failure, while strong liquidity can help even an otherwise weak institution to operate smoothly during difficult times. The internal and external sources of funds to meet the bank's requirements are examined. The degree of the banks reliance on volatile funds is also examined. The liquidity risk is evaluated by examining the assets liabilities maturity (ALM) profile, deposit renewal rates, proportion of liquid assets to total assets and the degree to which core assets (those which are relatively 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 along with CRR and SLR investments are important sources of reserve liquidity.
Infomerics also calculates the Liquidity Coverage Ratio (LCR) as defined under Basel III guidelines. According to RBI, the LCR for commercial banks is to be calculated as “Stock of High Quality Liquid Assets (HQLAs) divided by Total Net Cash Outflow during the next 30 calender days”. A separate section of Liquidity in the Press Release is made highlighting therein the LCR, as calculated above, asset-liability maturity profile and a synopsis of the short-term external funding support available to meet the near-term debt servicing obligations.
A bank's ability to generate adequate returns is important from the perspective of its shareholders as well as debt subscribers. The purpose of the evaluation here is to assess the level of future earnings and quality of earnings of the Bank concerned by analysing its interest spreads, non-interest income, operating expenses and credit costs. Business areas that contributes to the core earnings is evaluated for risks as well as for its earning prospects and growth rate. Profitable operations are essential for banks to operate as an ongoing concern. Yield on business assets and on investments are viewed in conjunction with cost of funds to arrive at the spreads earned by the bank. Net interest income (NII) and Net interest margin (NIM) are evaluated to arrive at the spread available to the Bank. Operating efficiency is also examined in terms of expense ratios. Quality of bank's earnings is also impacted by the level of interest rate and foreign exchange rate risks that the bank is exposed to. The overall profitability is reviewed in terms of Return on Total assets (ROTA) and Return on Net worth(RONW).
Apart from the factors mentioned above, specific features of the bonds are also taken into account for the purpose of rating as described below-
Loss Absorption Feature of Tier II bond under Basel III
Tier II Bonds under Basel III can be written off or converted into common equity upon declaration of point of non viability (PONV) by RBI.
CAPITAL ADEQUACY
FUNDING SOURCES
ASSET QUALITY
LIQUIDITY MANAGEMENT
EARNINGS PROFILE
Features of Additional Tier I (AT1) bond - perpetual debt instrument (PDI) under Basel III posing additional risk
However, payment of coupons on PDIs from the revenue reserves is subject to the issuing bank meeting minimum regulatory requirements for CET1, Tier 1 and Total Capital ratios at all times and subject to the requirements of capital buffer frameworks.
A Non-Viable Bank
As per the RBI guidelines a Non-Viable Bank is a bank which, owing to its financial and other difficulties, may no longer remain a going concern on its own in the opinion of the Reserve Bank unless appropriate measures are taken to revive its operations and thus, enable it to continue as a going concern. The difficulties faced by a bank should be such that these are likely to result in financial losses and raising the Common Equity Tier-1 capital of the bank should be considered as the most appropriate way to prevent the bank from turning non-viable. Such measures would include write-off / conversion of non-equity regulatory capital into common shares in combination with or without other measures as considered appropriate by the Reserve Bank
Given the additional risks of AT1 bonds, they are typically notched down from the rating of Tier II bonds.
CONCLUSION
Detailed inter-bank 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. The rating process ultimately determines the likelihood of the rated debt obligation being serviced in full and on time. All relevant quantitative and qualitative factors are considered together, as relative weakness in one area of the bank's performance may be more than adequately compensated for by strengths elsewhere. However, the importance 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 final rating decision is made by the Rating Committee after a thorough analysis of the bank's position over the term of the instrument with regard to business fundamentals.
1.breach of Common equity Tier 1 capital of 6.125% (5.5% till March 31, 2019) while the bank remains a going concern
2.declaration of point of non-viability (PONV) by RBI
FINANCIAL & OPERATING RATIOS CONSIDERED
In order to evaluate the aforesaid quantitative factors, various financial & operating ratios are calculated to see how a particular bank is placed over a three years time horizon on a standalone basis, as also with reference to its peers:
GROWTH
PROFITABILITY
GEARING
ASSET QUALITY
The trend of a bank’s performance may be measured in terms of its year-to-year growth majorly in respect of its revenue, profit and business level (which is defined by aggregate of its deposits & advances). Although these parameters are interlinked, they also have standalone bearing on bank’s performance. Nowadays, the non-interest income also plays a dominant role, besides the traditional lending function, and hence, they impact the overall revenue of the bank. Therefore, there is a need to assess the growth pattern of income and total assets.
The ultimate success of a bank, its cash flow, long-term sustainability and ability to absorb shocks in case of adversities depends upon its ability to generate profit. As perennially and even now, the major activities of bank centre around raising money from public and deployment of the same by way of advances. Credit/Deposit ratio stands for deployment of deposits in the form of advances.It is important to ascertain the overall borrowing cost and the overall earning percentage, the difference of which indicate the Interest Spread.In ascertaining the overall borrowing cost, the cost of deposit as well as the profile of deposit of a particular bank also assume significance as deposits are the main source of funds to a bank. But in order to evaluate the net interest earning on assets which are deriving such income, Net Interest Margin is perceived to be more candid indicator. Various other parameters are also calculated to ascertain the overall return with reference to total assets. RONW indicates the net earning ability of a bank on best use of its networth. If the company is highly leveraged, then the PAT will be lower due to higher interest expenses. Interest coverage implies the interest servicing ability of a bank.
As for ascertaining the capital structure and the leverage of a bank, more than the traditional gearing ratios, the Capital Adequacy is looked at to measure the adequacy of capital vis-a-vis its risk weighted assets. Banks being the financial outfits with funds are main input, they are expected to have higher gearing ratios as compared to manufacturing companies. Higher proportion of Tier I (core capital) in the overall capital is also carefully viewed.
The asset quality of a bank is the major broad parameter indicating the performance of a bank, these are measured in terms of proportion of Gross NPAs to Gross advances and Net NPAs to Net Advances. While Gross NPA ratio indicates the true asset quality of a bank, the Net NPA ratio is calculated after factoring the provision made for NPAs. However, the Net NPAs to Networthsignifies the ability of the company to absorb the impact of NPAs, while Provision Coverage indicates the extent of provisions made in respect of Gross NPAs.
Updated on March 2022