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National Credit Ratings Ltd

Financial Institutions Rating Methodology (Bank & NBFI)

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INTRODUCTION

NCR’s rating opinion reflects the credit worthiness of an issuer to meet financial obligations in timely manner over the life of the instrument. NCR has developed a comprehensive methodology for rating Banks keeping in view of the conceptual framework of BASEL II.

In addition, we analyze the regulatory environment, including the role of the supervisory authority, quality of bank supervision, reporting requirements and regulations relating to specific type of financial instruments and to specific financial products. This analysis also helps in evaluating a given bank’s competitive position within the industry. In order to carry out adequate analysis of a particular bank, it is helpful, to establish a “peer group”, of comparable banks.


THE ANALYTICAL PROCESS

NCR bases its analysis of banks on a number of quantitative and qualitative factors, the most significant of which are covered below. No one factor has an overriding importance or is considered in isolation and all the factors are reviewed in conjunction before assigning a rating.

 

 

QUANTITATIVE FACTORS


a)
CAPITAL ADEQUACY

Capital  Adequacy  is  a  measure  of  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. NCR examines the conformity of the bank to the regulatory guidelines on capital adequacy ratio. The size and the composition of the regulatory capital, internal capital generation, minimum capital adequacy requirement, stability of capital adequacy ratios and the presence of the hidden reserve are reviewed. A higher proportion of core capital (tier-1) in the total capital is viewed positively.


b)
ASSET QUALITY

Asset quality is the measure of Banks/FIs ability of managing credit risk. In reviewing the asset quality, NCR places due importance to Banks /FIs credit Appraisal mechanism portfolio management system rescheduling philosophy etc. in addition we also examine the structure of the bank’s balance sheet, including the relative proportions of different asset categories. In this context, we ask for a breakdown of lending by type of loan, size, maturity, currency, economic sector & geographical distribution. We also look at concentrations of credit risk, including large exposures (generally over 10% of equity) to individual customers & credit risk concentrations in particular industries.

With reference to the quality of other assets, we analyze the fixed income securities portfolio in terms of the general quality of the securities, their maturity, any undue concentration or particularly large individual exposures & the valuation of these securities. Likewise, an analysis of a bank’s interbank deposit & loan book will take into account size, maturity, & concentration of the book as well as the creditworthiness of the counter parties.

Banks are taking on increasing off-balance sheet commitments, & it is important to analyze the risks involved. Such commitments include guarantees & letters of credit as well as derivatives.


c)
EARNINGS QUALITY

A Bank’s solvency is reflected from its profitability and is therefore an important area for analysis. NCR looks at the historical trend of a Bank’s earnings performance, the stability and quality of its earnings and the capacity to generate profits. NCR analyzes the composition of income of the bank by segregating it into those generates from fee based and fund based activities. In the process NCR also reviews the net interest income, non-interest income, interest rate policy, product mix management, risk vs. return policy, risk appetite to increase earning etc. In the cost efficient side NCR focus cover a wide range of measurements such as cost efficiency in terms of cost to income ratio, trends on Net Interest Margin, Net Non Interest Margin and Net Operating Margin. The overall profitability is reviewed in terms of Return on Equity, Return on Assets and Earning per Share. NCR compares the Bank’s performance on each of the above parameters with its peers. Analysis is carried out to identify the relative position of the Bank in its present operating environment.


d)
LIQUIDITY

NCR analyzes the structure and diversification of a bank’s funding base, concentration of deposit or borrowing, significant trends in funding sources and in the bank’s liquidity. NCR also evaluates the asset-liability maturity structure, deposit renewal ratios, proportion of liquid asset to total asset and the extent to which core asset are fund by core liabilities. We consider the core and non-core deposit mix and identify various indicators to assess the mix of corporate and retail deposits.  As far as liquidity is concerned, we analyze both the bank’s   internal   sources   of   liquidity   (marketable securities, maturing loans, etc.) and external sources (such as access to capital markets, stand-by lines from other  banks  and  rediscount  facilities  at  the  central bank). 

The liquidity indicators are sensitized to measure coverage against total borrowings, maximum possible stress analysis by measuring coverage against the portion of contingent liabilities that may, maturate within a time horizon. The Impact of interest rate volatility on deposit and its trend is also examined in the evaluation process of liquidity strength of Banks.


e)
COMPETITIVE POSITION

The competitive strength of the bank in terms of its cost structure is analyzed. The proportion of low cost deposits to total deposits and the deposit mix is examined. Average as well as incremental cost of funds is examined in the context of prevailing interest rate regime. The ability of the bank to mobilize additional deposits at competitive rates is examined critically.

 

f) SIZE AND MARKET PRESENCE

The size of a bank in terms of its asset, liabilities and branch network may have a bearing on the bank’s competitive position. NCR analyses the diversification of activities undertaken by a bank, in terms of geographical location and industrial sectors. It also examines the diversity of services and products it provides to customers, and its ability to create new products.

 

NCR evaluates the quantitative factors in terms of absolute numbers, ratios and their relativity and trends as well. NCR also compares the bank’s performance on each of the above parameters with its peers. A detailed analysis is done to assess the relative strengths and weaknesses of the bank in its present operating environment.

 

QUALITATIVE FACTORS

Some of the qualitative factors that include our rating process include the following:

 

a) RISK MANAGEMENT

This includes an analysis of the bank’s appetite for risk and the systems it has in place for managing risks related to the pliilar-1 of the conceptual framework of BASEL II. Three kinds of risk such as credit risk, market risk and operational risk are considered to determine the Minimum Capital Requirement. We examine the independence and effectiveness of the risk management function. The Bank’s risk management policy, procedure and processes in place and the degree to which these rules and procedure are adhered to are also examined. We endeavor to assess the senior management’s understanding and involvement in risk management issues. In the recent past there has been perceptible improvement in the risk management systems of our Banks under the supervision and guidance of the Bangladesh Bank.

 

i. CREDIT RISK:

NCR evaluates all the credit risks arising from on balance sheet activities as well as off balance sheet commitments. We examine the structure of the Bank’s Balance Sheet, including the relative proportions of different asset categories. Generally, loans and advances constitute the most significant portion of assets of a commercial bank and therefore a comprehensive review of the credit portfolio is essential for the assessment of the credit risk. We classify the loans and advances by type of loans, size, maturity, economic sector and geographical location. We also look at concentrations of credit risk, including large exposures to individual customers/group and concentrations of credit in particular industrial sectors. We thoroughly analyze the non performing loan portfolio and the required and actual provisioning for assessing the underlying risk. With reference to the other assets, we analyze the general quality of the securities, their maturity, any undue concentration and the valuation of these securities. An analysis of the Bank’s inter-bank deposits and loan books will take into account the size, maturity and concentration as well as the creditworthiness of the counterparties. We analyze the off balance sheet commitments such as Bank Guarantee, Letter of Credit.

 

ii. MARKET RISK:

Our analysis of market risk covers all structural & trading risks across a bank’s entire business. As far as structural risks are concerned, we examine the bank’s asset & liability management strategy, & the role of position taking, hedging & accounting in this strategy. We examine the sensitivity to market risks in terms of changes in interest rates, foreign exchange rates and commodity prices. We calculate the ratio of rate sensitive assets and liabilities for assessment of the impact of changing interest rates on a bank’s margin of profit.

 

iii. OPERATIONAL RISK:

Operational risk is defined as all other risks other than market, credit & liquidity risk. In the context of Basel II, however, the Basel committee has adopted a narrower definition of Operational risk: “the risk of loss resulting from inadequate or failed internal processes, people & systems or external events”. Our analysis of operational risk focuses on a number of issues, including (a) a Bank’s definition of such risk b) the quality of its organizational structure c) operational risk culture d) the development of its approach to the identification and assessment of key risks e) data collection efforts; and f) overall approach to operational risk quantification and management.

 

b) Ownership and Support

The ownership of and potential support available to a bank is crucial to our overall rating assessment. We analyze the stability of the shareholding structure of the bank, as well as the ability and willingness of either its owners or the government to bail out the bank in case of need.

The assessment of ownership pattern and shareholders support in a crisis is an important factor in rating a bank. In case of public sector banks the willingness of the government to support the bank for bail out from crisis is important. The support from the owners is particularly relevant in case of larger sized banks, whose failures could have a contagious effect on the confidence in the overall financial system.

 

c) MANAGEMENT QUALITY

A well defined management structure is an important ingredient for the success of a bank. NCR places strong emphasis on the basic philosophy of asset and liability management (ALM). The composition of the board, frequency of change of CEO and the organizational structure of   the bank are considered. NCR looks at the dependence of management team on one or more persons, coherence of the team, and the independence of the management from major shareholders. The bank’s 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. It also analyses the quality and credibility of management’s strategy, examining plans for future internal or external growth. When evaluating future plans, significant credit is given for delivering on past projections and sticking to strategies. We focus on the modern banking practices and systems, degree of computerization, capabilities of senior management, personnel policies and extent of delegation of powers. NCR reviews the IT system and its adequacy to meet the growing need of various products and services.

 

d) CORPORATE GOVERNANCE

A bank’s corporate governance practices can have a material impact on its credit quality. In assessing corporate governance, NCR analyses governance data and information systematically and also performs more contextual, qualitative reviews of an individual entity’s governance practices. The important aspects, which are looked at by NCR while evaluating the quality of corporate governance include, the independence and effectiveness of the board of directors, oversight of related party transactions that may lead to conflicts of interest, board oversight of the audit function, executive and director remuneration, complex shareholding/ownership structures.

 

e) COMPLIANCE WITH STATUTORY REQUIREMENTS

NCR examines the track record of a bank in complying with SLR/CRR and other norms and practices as specified by the Bangladesh Bank.

 

f) ACCOUNTING QUALITY

Rating depends profoundly 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.

 

g) FRANCHISE VALUE

We take into account the strength and depth of a bank’s franchise as well as its ability to safeguard existing business and gain new business. The joint venture/strategic alliance with foreign/local partners, management contract/technical collaboration with foreign/local partners and a bank’s alliance/arrangement with international financial institutions or any certifications from such institutions are also taken into account.

 

The relevant quantitative and qualitative factors are considered together for assessment of the relative strengths weaknesses of a bank. The quality of the management, the bank’s operating environment and its competitive position in the industry are assessed to forecast how well the bank is positioned in the future. The final rating decision is made by the Rating Committee after thorough analysis of the bank’s position with regard to business fundamentals. 

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For further details please contact:

National Credit Ratings Ltd

3 Bijoy Nagar (2nd & 3rd Floor)

Dhaka-1000

Tel: 0088-02-9359878, Fax: 0088-02-9332769

 

Website: www.ncrbd.com

 

 
NOVEMBER 2010 
DISCLAIMER
NCR has used due care in preparation of this document. Our information has been obtained from sources we consider to be reliable but its accuracy or completeness is not guaranteed. NCR shall owe no liability whatsoever to any loss or damage caused by or resulting error in such information. None of the information in this document may be copied or otherwise reproduced, stored or disseminated in whole or in part in any form or by any means whatsoever by any person without NCR’s written consent. Our reports and ratings constitute opinions, not recommended to buy or to sell.
Tel: 88 02 9359878, Fax: 008 02 9332769 




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