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National Credit Ratings Ltd

Bank Loan Rating Methodology

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In rating bank loan facilities, NCR follows the similar process it follows in rating entities and debt instruments. NCR rates both funded and non-funded facilities extended by banks. All banks in Bangladesh are required to adopt standardized approach for measurement of risk weighted assets and computation of capital requirement in line with the revised risk based capital adequacy framework recommended by Basel II. The credit risk of an exposure is governed by four parameters that need to be estimated are i) the Probability of Default (PD), ii) the Loss Given Default (LGD), iii) the Exposure at Default (EAD) and iv) Maturity according to the IRB approach. Bank Loan Rating (BLR) reflects NCR’s opinion on the ability of an entity to pay financial obligations in time as per the specific terms of the facility. NCR’s BLR rating addresses the probability of default, expected loss in the event of default and likelihood of recovery.

 

Relationship between Entity Credit Rating and Bank Loan Rating:

 

The entity Credit rating is an opinion on an entity’s overall credit quality: its capacity to pay its financial obligations on a timely basis and the level of expected credit risk. It generally indicates the likelihood of default regarding all financial obligations of an entity, because the entities that default on one debt type usually stop payment on all debt types. Entity rating is not specific to any particular financial obligation, as it does not take into account the specific nature or provisions of any particular obligation. As the entity credit rating provides an overall assessment of an entity’s credit quality, it is used for a variety of financial and commercial purposes.

 

Bank Loan Rating (BLR) focuses on both the risk of default and likelihood of ultimate recovery in the event of default. Although the probability of default is not influenced by the likelihood of realization of a debt from the liquidation of security, the collateral security, however, have significant impact on the LGD (loss given default) component of the credit risk exposure. In evaluating the collaterals and other credit enhancement features, NCR would, inter-alia, look at the nature of collateral, ease of reliability and realizable values to estimate the ultimate recovery in the event of default. A primary purpose of BLR is to assist bankers, through a single rating measure, in assessing both probability of default and expected recovery prospects of the defaulted loan. BLR would facilitate differentiating between the more effectively secured loans from those that may be secured in name only. Bank loan ratings will have a prefix of ‘BLR’ attached to the rating symbol. Assessment of LGD focuses exclusively on expected loss and recovery in the event of default, with no relationship to underlying PD of a given loan.

 

Recovery Rating focuses exclusively on expected loss and recovery in the event of default, with no relationship to underlying default likelihood of a given loan. Each recovery rating is defined in terms of an expected recovery range. The post default recovery is assessed by using separate scale, symbols and definitions as given below:

 

 

 

Rating Scale- Symbols and Definitions

Rating Scale

Description

Recovery Expectation

R1

Exceptionally strong recovery prospects

100% of principal

R2

Very strong recovery prospects

100% of principal

R3

Strong recovery prospects

80% -100% of principal

R4

Moderate recovery prospects

50% - 80% of principal

R5

Weak recovery prospects

Below 50% of principal

 

· Full recovery of principal means 100% of the principal amount outstanding at the time of default to be recovered within a period of 24 months from the date the default is established and recovery proceedings initiated. NCR uses the concept of ‘nominal amount of recovery rather than the present value.

 

· Recovery ratings are primarily on an ordinal scale and given the numerous factors influencing recoveries over time, the scale does not attempt to predict a precise percentage recovery. The scale reflects relative recovery expectations and above-mentioned percentages are indicative of likely recovery rather than precise estimates.

 

NCR evaluates several distinct factors while determining the bank loan ratings and recovery ratings for a particular loan. These include:

 

Nature of charge on collateral

 

The most critical to ascertain recovery probability is the type of charge - exclusive, shared, unsecured, subordinated, etc. – created on the collateral by the lender. The nature of charge determines the priority the lender gets in proceeds realized through disposal of underlying asset in the event of default. The exclusive secured collateral arrangement is considered the superior structure compared to pari passu charge or second lien. In establishing the priority of the charge, NCR would rely on the opinion of the legal division/counsel of the bank.

 

The type and the quality of the collateral security

 

The type and quality of the collateral –i.e., receivables, current assets, fixed assets, all assets, property, plant and equipment, equity securities, etc.– are critical because that determine how much stress the secured assets can absorb and still hold their values. This is of critical importance because in certain cases the ultimate value of a particular security is completely independent of fortunes of the underlying entity- for example a pool of general purpose vehicles.

 

Loan-to-value

 

Loan-to-value refers to the amount of the loan being secured in relation to the amount of the collateral security. The amount of the collateral, as opposed to its type and quality, is equally critical. It has been observed that all types of collateral security, even of lower quality and less liquid can be effective in protecting creditors if there is enough of it in relation to the loan to provide substantial cushion to absorb shrinkage in value.

 

Relationship:

 

The customers historical performance with the bank through turnover in the account (in case of continuing credit), compliance of the covenants, utilization of limit and repayment behavior are important factors for assessment of the risk of default of a specific credit facility.

 

Control over the collateral

 

The control over the collateral by the lender, during both pre- and post- default periods, is important. The tighter the monitoring and control of the collateral, the greater likelihood that in the event of default the lenders will actually benefit from the protection against loss that they were counting on when the loan was first made.

 

A comprehensive evaluation of all these factors helps NCR to determine the recovery likelihood. Based on NCR’s assessment of ultimate expected recovery of principal in the event of default, the loan rating will be ‘notched up or down’ by one or more notches from the underlying borrower entity’s credit rating. The greater the likelihood of recovery, the more NCR may notch up the loan rating. In case NCR is not doing the entity credit rating of the borrower, it would undertake shadow entity rating for this purpose. Relationship between an entity’s credit rating and rating of its loan after factoring in recovery analysis is explained in the following table:

 

Relationship between Bank Loan Rating and Entity Credit Rating

Recovery Rating

Bank Loan Rating
Notching up / down to Entity Credit Rating (ECR)

Description

R1

ECR plus 3 or 4 notches

Exceptionally strong likelihood of full recovery of principal and interest in the event of default

R2

ECR plus 1 or 2 notches

Very strong likelihood of full recovery of principal and interest in the event of default.

R3

Un notched

Strong likelihood of substantial recovery of principal in the event of default; minimal loss expected

R4

ECR minus 1 notches

Likelihood of moderate recovery of principal in the event of default; despite potentially significant loss exposure

R5

ECR minus 2 notches

Weak likelihood of recovery attributable to collateral or structure in event of default

 

While NCR does not attempt to predict the ultimate outcome of recovery proceedings, the exercise establishes the recovery risk profile by assessing the characteristics of various collateral securities. The probability of default increases as credit quality weakens - lower the entity rating higher the probability of default. On the contrast, the effect of collateral diminishes as the underlying credit profile improves. Intuitively, the higher the credit quality, lower the requirement of collateral as an alternative source of repayment.

 

Rating Scales for BLR:

 

NCR assigns the same scales as those it uses in assigning ratings to debt instruments. Some funded continuing credit facilities are sanctioned for one year. These facilities are often rolled over and therefore can be treated as long term exposures from bank’s perspectives. NCR, therefore, assigns ratings to these facilities on long term scale. Other funded facilities such as Trust Receipt, LIM, Packing Credit, bill discounting etc have maturity less than six months are therefore rated on the short term scale. NCR assigns rating to non funded facilities such as Letter of Credit, Bid bond/PG etc on the short term scale. On the invocation of a Bank Guarantee, bank makes payment to a third party on behalf of the borrower. The borrower is required to pay the bank as per the terms of the facility within a short time.

 

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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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