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Banks are specialised institutions that require a unique analytical approach in order to accurately assess their risk profile. CI has a consistent and coherent bank rating methodology which is applied to all rated banks. We take a holistic approach to the assessment of bank risk and analyse a substantial number of quantitative and qualitative factors before assigning ratings to individual institutions.
The factors that influence a bank's creditworthiness may be broadly categorised as external and internal, and both external and internal factors can be characterised as either financial or non-financial.
External factors refer to the business environment in which the bank operates and financial factors external to the bank include economic growth, interest and exchange rates, demand for credit, and the propensity to save. Non-financial external factors include political interference in the banks operations and pressure to lend to related parties.
Internal factors relate to the bank's own unique character, which depends on a range of factors such as shareholders, operations and mandate. The most important financial factors affecting the credit standing of a bank are asset quality, capital adequacy, liquidity/funding and profitability. Key non-financial factors include ownership structure, management quality and ability, systems and controls on lending, and trading and treasury operations.
CI's approach to bank analysis is built on six pillars:
- Operating Environment
- Ownership and Governance
- Franchise Value
- Management and Strategies
- Risk Profile
- Financial Profile
The first four pillars comprise largely qualitative factors (although the analysis of the operating environment will include substantial quantitative work on a country's economy) whilst the last two pillars look specifically at financial factors.
1. Operating Environment
CI views a bank's operating environment as crucial, particularly in emerging markets. A bank may well possess a strong financial profile, but a weak or volatile operating environment could reduce its overall credit quality. We therefore examine a country's economic structure, paying particular attention to the level and distribution of per capita income, the diversification of the production and export bases, the susceptibility of the economy to exogenous shocks, and the pace and depth of structural change. We consider the outlook for the real economy, including the prospects for key industries and the condition of the labour market, and assess the appropriateness of the macroeconomic policy mix and the stability of the exchange rate regime. CI takes into account developments in the money, capital and real estate markets and considers expected changes in government policy that may impact the banking sector. The stability of the political situation and the risk of political factors triggering economic and financial instability are also assessed.
CI examines the regulatory framework for the banking sector and assesses the ability and willingness of supervisors to enforce and verify compliance with prudential regulations and to intervene effectively at times of stress.
The level of financial disclosure and the reliability of the disclosure are important considerations in emerging markets, hence the standard of auditing and financial accounting within the country is also evaluated. We gauge the reputation and quality of the bank's own auditor and the accuracy of the financial accounts of the bank's clients.
CI's assessment of the operating environment also includes an examination of the country's legal system. CI reviews relevant documentation and speaks to legal firms and other participants in the banking sector to gain an understanding of the overall framework. A key consideration in many developing countries is whether the legal system is keeping pace with changes in the political, economic, technical and financial spheres.
2. Ownership and Governance
The capacity and willingness of a bank's owners to assist the bank in the event of difficulties is a significant factor in CI's foreign and local currency ratings and the likelihood that financial assistance will be forthcoming from private owners or the government is captured explicitly by our support ratings. We examine the stability of the bank's ownership structure, as well as the objectives of the owners and their ability and willingness to support the bank. We also look at the level of independence enjoyed by the bank's management and whether the bank is required, or is likely to be required, to support the owners' other activities, for example by lending to related parties at below commercial rates
3. Franchise Value
CI places significant emphasis on a bank's franchise and it forms an important element of both a bank's foreign currency ratings and financial strength ratings. CI assesses the bank's position in the domestic banking sector in terms of market share in assets and various business sectors such as loans, mortgage lending, deposits. We consider the bank's ability to support existing business activities and to develop new business lines. We regard franchise strength as an important factor in earnings performance, both current and future.
4. Management and Strategies
Management needs technical and organisational skills, as well as good judgement, to cope with the many types of risk encountered in banking. Weak management is unable to control risks and is therefore liable to make wrong decisions that lead to losses. The problems of weak management are accentuated when banks move into new areas of business. As part of our assessment of a bank's management, we look at the organisational structure of the bank, the independence of the management team from the bank's owners, and the management's short- and medium-term strategic and policy objectives. We also look at the management's track record and assess its ability to plan and react to changes in the environment. The potential for technical mismanagement is an important issue and we therefore assess the adequacy of internal controls and authorisation and approval procedures, as well as the strength and independence of the internal audit department.
5. Risk Profile
CI evaluates an institution's risk profile by examining the risk management culture of the organisation, its activities, its risk controls and systems, and the overall exposure to financial risk stemming from the bank's on and off-balance sheet activities. Specific financial risk areas CI assesses include market risk, operational risk and credit risk.
Market risk is the risk of losses due to movements in market prices (including interest rates, exchange rates, equity prices and commodity prices) and is closely associated with asset and liability management. CI analyses the bank's trading activities and looks at the risk management techniques employed by the bank, such as Value-at-Risk (VAR) and stress testing.
Many banks have upgraded or are in the process of upgrading their risk management systems in line with the implementation of Basel II in 2007/08. A considerable amount of CI's review of the bank's risk profile is aligned to the methodology, policies and procedures outlined in Basel II. We pay close attention to a bank's preparation for Basel II and the likely impact it will have on a bank's capital position. A number of banks have developed or are in the process of developing internal rating systems in line with the internal ratings based approach.
One of the major impacts of Basel II is in regard to operational risk. Operational risk will require a capital charge under Basel II and banks are developing more sophisticated models to measure and monitor operational risk. Basel II defines operational risk as, "the risk of loss resulting from inadequate or failed internal processes, people and systems or external events". Strategic and reputation risk is excluded from the definition but legal risk is included. Legal risk is generated by the possibility that aggrieved or dissatisfied customers, employees or other third parties may instigate litigation. CI views this as an important risk to be taken into account. A similar view is taken of strategic risk, which we take into account in our examination of strategies and management. As outlined above, we continue to place significant emphasis on operational and internal systems, structures and the quality of personnel.
6. Financial Profile
CI's bank rating methodology places substantial emphasis on the financial profile of a bank and, inter-alia, financial and ratio analysis. Our approach is to look at the four main areas of a bank's financials: asset quality, capital, liquidity, and profitability. CI has prepared its own proprietary software for the presentation of banks' audited financial statements. Bank results are carefully analysed and entered into CI's spreadsheets consisting of balance sheets, profit and loss accounts and performance ratios.
Asset Quality/Credit Risk - Despite the increasing sophistication of banks and growing market risk, credit risk remains the principal risk for most banks. An accurate assessment of credit risk is sometimes challenging due to inadequate disclosure and the often subjective nature of loan classification and write-offs. CI's approach is to look intimately at the loan portfolio to identify trends in the market. For the purposes of this analysis, "loans" would include credit-based derivative positions such as credit default swaps.
CI's methodology to credit risk also entails a thorough analysis of the entire balance sheet, looking at different asset categories, whether they be securities (quoted and unquoted), loans, placements or other assets. We also analyse all off-balance sheet items and commitments for credit risk purposes to assess quality. It is now more common for banks to have off-balance sheet commitments apart from guarantees and letters of credit. These include derivatives, such as interest rate and credit swaps. We analyse the make-up of the balance sheet to ascertain the asset mix and concentration. For most retail and commercial banks, the loan portfolio represents the most important asset category. We ask for a complete breakdown of the loan portfolio, including type, size, maturity, currency, geographical distribution and economic sector.
For banks where the major risk is not connected to loan assets (for example investment banks), CI focuses on the investment assets such as listed and unlisted securities, placements, real estate, corporate investments, and the associated credit and/or market risk.
Capital - Capital provides the bank with protection to absorb unexpected losses and allows the bank to operate in a solvent manner. A bank's capital also provides leverage to the balance sheet. Excess or strong capital gives the bank opportunity to expand the asset base and, in turn, increase earnings. Moreover, it provides a greater cushion. As a result, the level of capital and risk weighted capital adequacy are fundamental factors in CI's assessment of bank creditworthiness. CI pays close attention to the makeup of the capital and examines both Tier 1 and Tier 2 capital. Specifically we look at the quality of the capital and what proportion is made up of common equity. We look at the amount of subordinated debt together with the level of preference shares and hybrid debt. We also identify the extent of revaluation reserves and the frequency of this facility and examine the possibility of any hidden reserves on the balance sheet.
Liquidity and funding - Weak liquidity is often the main cause of a bank's failure. Conversely, good liquidity can often help an otherwise weak bank to survive. Accordingly, CI focuses on the level of a bank's current liquidity and structure of its funding position. We also analyse the bank's ability to fund itself under stress conditions. This is particularly important for emerging market banks where conditions can change rapidly, as can creditworthiness. As such, the prime risk to a bank's funding is not being able to renew or replace maturing funding liabilities either at all or at a commercially appropriate price. CI analyses the funding mix and structure to ascertain the degree of funds derived from more stable sources, such as core customer deposits, and the 'stickiness' of such funding.
In our examination of bank's liquidity position, CI assesses the profile of assets and liabilities and their respective maturities. We look at a bank's maturity ladder through different time gaps to identify any large mismatches. Large mismatches may be a cause for concern if a liquidity event occurs. Similarly, we assess the asset and liability structure in respect to interest rate matching to identify any significant mismatches of contractual interest rates at different time frames. We examine the mix of fixed and floating rate assets and liabilities and analyse the asset liability profile in respect to currency matching through calculating foreign currency assets to foreign currency liabilities.
Profitability - Profitability and earnings are a significant determinant of a bank's ability to survive in the long run. Profitability and earnings also reflect the quality of the asset base, funding sources and costs, and franchise value; they are also a reflection of the bank's management and strategy. A detailed analysis of the bank's audited accounts and notes is crucial for an understanding of the bank's true profitability and earnings prospects. We pay close attention to different accounting practices and standards between banks and countries in order to be consistent in our analysis and to identify any sub-standard practices. Different valuation or booking methods, the accrual of interest on non-performing loans, asset sales, tax treatment, depreciation and other such variables within the profit and loss statement can alter the bottom line significantly.
CI takes a line by line approach to all areas that drive the profit and loss statement of a bank. We aim to assess the true quality of a bank's earnings to identify sustainability. We look for earning drivers such as core interest income activities from sustainable activities such as lending.