Regulatory Framework and Role of Domestic Credit Rating Agencies in Bangladesh

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Regulatory Framework and Role of DomesticCredit Rating Agencies in Bangladesh

Jiro Tsunoda, Muzaffar Ahmed, and Mohammed Tajul Islam

No. 21 | November 2013

South AsiaWorking Paper Series


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ADB South Asia Working Paper Series

Regulatory Framework and Role of DomesticCredit Rating Agencies in Bangladesh

Jiro Tsunoda, Muzaffar Ahmed, and

Mohammed Tajul Islam

No. 21 November 2013

Jiro Tsunoda is principal portfolio management specialist,

Asian Development Bank. Muzaffar Ahmed is president

and CEO, Credit Rating Information and Services,

Bangladesh. Mohammed Tajul Islam is vice president and

head of ratings, Credit Rating Agency of Bangladesh.


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Asian Development Bank6 ADB Avenue, Mandaluyong City1550 Metro Manila, Philippineswww.adb.org

2013 by Asian Development BankNovember 2013

Publication Stock No. WPS146204

The views expressed in this paper are those of the author and do not necessarily reflect the views and policies of theAsian Development Bank (ADB) or its Board of Governors or the governments they represent.

ADB does not guarantee the accuracy of the data included in this publication and accepts no responsibility for anyconsequence of their use.

By making any designation of or reference to a particular territory or geographic area, or by using the term countryin this document, ADB does not intend to make any judgments as to the legal or other status of any territory or area.

Note: In this publication, $ refers to US dollars.

The ADB South Asia Working Paper Series is a forum for ongoing and recently completed research and policystudies undertaken in ADB or on its behalf. The series is a new knowledge product and replaces the South AsiaEconomic Reportand South Asia Occasional Paper Series. It is meant to enhance greater understanding of currentimportant economic and development issues in South Asia, promote policy dialogue among stakeholders, andfacilitate reforms and development management.

The ADB South Asia Working Paper Series is a quick-disseminating, informal publication whose titles couldsubsequently be revised for publication as articles in professional journals or chapters in books. The series ismaintained by the South Asia Department. The series will be made available on the ADB website and in hard copy.

Printed on recycled paper


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CONTENTS

I. THE GENESIS OF DOMESTIC CREDIT RATING AGENCIES IN BANGLADESH 1

II. CREDIT RATING AGENCIES IN BANGLADESH THAT ARE RECOGNIZED AS

EXTERNAL CREDIT ASSESSMENT INSTITUTIONS BY BANGLADESH BANK

2

III. HOW RATING AGENCIES ARE GOVERNED GLOBALLY 3

IV. REGULATORY FRAMEWORK FOR DOMESTIC CREDIT RATING AGENCIESIN BANGLADESH

3

A. Credit Rating Companies Rules 1996 3 B. Dhaka Stock Exchange Direct Listing Rules 4 C. Banking Regulation and Policy Department, Bangladesh Bank,

Circular Number 05 Dated 29 May 2004 and Circular Number 06Dated 13 March 2011

4

D. Guidelines of Bangladesh Bank for Capital Adequacy Frameworkand Accreditation of External Credit Assessment Institutions

5

E. Circular of the Chief Controller of Insurance 5

V. PERFORMANCE OF DOMESTIC CREDIT RATING AGENCIES INBANGLADESH WITH REFERENCE TO THE ADB HANDBOOK ONBEST PRACTICE COMPLIANCE

6

VI. CREDIT INFORMATION BUREAU VERSUS CREDIT RATING AGENCY 7

A. What Is a Credit Information Bureau? 7 B. Credit Information Bureau in Bangladesh 7 C. Regulatory Framework for the Credit Information Bureau in Bangladesh 8 D. Credit Information Bureau versus Credit Rating Agencies 9

VII. IMPLEMENTING THE BASEL II GUIDELINES OF CAPITAL ADEQUACYFRAMEWORK FOR COMMERCIAL BANKS AND THE ROLE OFDOMESTIC CREDIT RATING AGENCIES

9

A. Status of External Credit Assessment Institutions 11 B. Monitoring and Mapping the Rating Quality of External Credit

Assessment Institutions12

C. Risk Weight Assignment under Basel II and Prospects of ExternalCredit Assessment Institutions

15

D. Basel II Implementation: Bankers Challenges in Credit Risk Rating 16

VIII. INTERNAL CREDIT RATINGS BY COMMERCIAL BANKS IN BANGLADESH 21

IX. PROSPECTS FOR CREDIT RATING IN BANGLADESH WITHIN ABASEL II REGIME

22

X. BANGLADESH BANKS MOVE TOWARD RATING SMALL AND

MEDIUM-SIZED ENTERPRISES

23

XI. CONCLUSIONS 24


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ABSTRACT

The Securities and Exchange Commission Bangladesh (SECB) promulgated the CreditRating Companies Rules, 1996 for investor protection in issuing debt securities and public

issue of shares. Two domestic credit rating agencies (DCRAs) were licensed by SECBafter 2002, which were later accorded status of external credit assessment institutions(ECAIs) by Bangladesh Bank. Thereafter, SECB and Bangladesh Bank issued rules andregulations towards mandatory ratings which led to the building of information frameworkscritical to the efficiency of financial markets. Investors could now optimize their riskreturnprofiles, monitor their portfolios through regular surveillance and credit rating adjustments,and have timely information for trading and risk management. Recently, DCRAs have cometo play a more crucial role since the capital adequacy of commercial banks has been tied torating assessment of bank investments. The use of credit rating is expected to lead to theestablishment of acceptable measures of credit risk evaluation so that commercial banks canmeet Basel II regulatory prescriptions. As Bangladesh Bank accords ECAI status to moreDCRAs, banking sector financing to corporate borrowers is receiving a boost. The number of

DCRAs operational in Bangladesh has risen from two to seven between 2010 and 2013.Furthermore, Bangladesh Bank plans to introduce ratings for small and medium-sizedenterprises (SMEs) and a customized credit assessment framework for SMEs including aseparate rating scale and notation that sets SME ratings apart from the usual bank loanratings. Access to adequate financing is still a chronic problem for SMEs in the Asian regionand here, credit ratings could fill a critical gap in the credit information continuum, movingaway from collateral-based lending to risk-based lending.


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ABBREVIATIONS

ACRAA Association of Credit Rating Agencies in AsiaACRL Alpha Credit RatingACRSL ARGUS Credit Rating ServicesADB Asian Development Bank

BCBS Basel Committee on Banking SupervisionBRPD Banking Regulation and Policy DepartmentCAR capital adequacy ratioCDR cumulative default rateCIB credit information bureauCIR credit information reportCRA credit rating agencyCRAB Credit Rating Agency of BangladeshCRC Rules 1996 Credit Rating Companies Rules 1996CRG credit risk gradingCRGM credit risk grading modelCRISL Credit Rating Information and Services

DCR Duff and Phelps Credit Rating CompanyDCRA domestic credit rating agencyDSCR debt service coverage ratioEAD exposure at defaultEBITDA earnings before interest, taxes, depreciation and amortizationECAI external credit assessment institutionECRL Emerging Credit RatingFISL Financial Intelligence ServicesIDRA Insurance Development and Regulatory Authority BangladeshIOSCO International Organization of Securities CommissionsIPO initial public offeringsIRBA internal rating based approach

LGD loss given to defaultLRA lending risk analysisMARC Malaysian Rating CorporationMCR minimum capital requirementNBFI nonbank financial institutionsNCRL National Credit RatingsNRB nonresident BangladeshiNRSRO nationally recognized statistical rating organizationPACRA Pakistan Credit Rating AgencyPSE public sector entitiesRAM Rating Agency MalaysiaRBCA risk based capital adequacy

ROA return on assetRWA risk weighted amountS&P Standard & PoorsSECB Securities and Exchange Commission of BangladeshSMEs small and medium-sized enterprisesSMESPD Small and Medium Enterprises and Special Programmes DepartmentTk taka (Bangladesh currency)Turk Rating Istanbul International Rating ServicesWCRCL WASO Credit Rating Company (BD)


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Regulatory Framework and Role of Domestic Credit Rating Agencies in Bangladesh 1

I. THE GENESIS OF DOMESTIC CREDIT RATING AGENCIES IN BANGLADESH

1. The financial sector in Bangladesh consists of banks, nonbanking financial institutions(NBFIs), house-building financing companies, general insurance companies, life insurancecompanies, and a number of government-owned specialized institutions. In addition, the capitalmarket of Bangladesh consists of a large number of institutions working under the regulatory

umbrella of the Securities and Exchange Commission of Bangladesh (SECB). The spectrumalso includes bonds and securities, mutual funds, the two bourses of the country, brokeragehouses, merchant banks, and asset management companies. These institutions need theservices of rating agencies as part of regulatory compliance and in many cases to use the samefor business promotion and credibility enhancement.

2. In recognition of the importance of credit rating and its role in protecting the interests ofinvestors in the capital market, the SECB formulated the Credit Rating Companies Rules 1996(CRC Rules 1996) as a first step to ushering credit rating into Bangladesh. The above regulationprovided that No issue of debt security or public issue of shares (including right shares atpremium) shall be made by an issuer unless the issue is rated by a credit rating company anddeclaration about such rating is given in the offer document, prospectus or right share offer

document as the case may be.1

3. In order to ensure appropriate quality of rating in the local market, the SECBcompulsorily required domestic credit rating agencies (DCRAs) seeking licenses to have jointventure or technical collaboration with any established rating agency of international repute.

4. When Bangladesh Bank first issued a circular among rating agencies invitingexpressions of interest towards being recognized as external credit assessment institutions(ECAIs), two rating agencies had presence in BangladeshCredit Rating Information andServices (CRISL) and the Credit Rating Agency of Bangladesh (CRAB).

5. Credit Rating Information and Services (CRISL) was the first rating agency in the

country, set up in 1995 as a joint venture of Rating Agency Malaysia, JCR-VIS Credit RatingCompany of Pakistan, and several financial institutions and professionals in Bangladesh. CreditRating Information and Services was licensed by SECB to operate as a rating agency in thecapital market in April 2002.

6. Credit Rating Agency of Bangladesh (CRAB) was established as a local rating agency in2003. Based on its technical collaboration with ICRA, India, a subsidiary of Moodys InvestorsService, United States, it was licensed by SECB in 2004.

7. As was mandatory under CRC Rules 1996, CRISL started rating a few listed banks whilethose banks were going for a rights offer of shares. The ratings created great sensation inbanking circles and elicited interest among banking companies and regulators alike.

Bangladesh Bank on 29 May 2004 issued a circular that made rating mandatory for all banksgoing public. It was envisioned that a banks rating report would help its investors remain betterinformed about the bank, promote transparency, and protect the interests of the depositors.2In 2006 Bangladesh Bank issued another circular that made the annual credit rating mandatoryfor all banks, thereby embedding credit rating firmly into the banking process in Bangladesh.3

1 Notification No. SECB/Section 7/117, dated 24 June 1996.2 Bangladesh Bank Circular Letter No. 05, dated 29 May 2004.3 Bangladesh Bank Circular Letter No. BRPD 06, dated 5 July 2006.


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4 ADBSouth Asia Working Paper Series No. 21

22. In line with the regulation, 93 issues were enlisted with the stock exchanges throughinitial public offerings (IPOs) between 2004 and 2013; on average, 10 IPOs came into themarket every year.4 Of these, Credit Rating Agency of Bangladesh (CRAB) rated 49 issues,CRISL rated 36 issues, and the remaining 8 issues did not have any ratings.5The trend showsthat an average of 810 issues would come under purview of rating in a bid to comply with theregulation.

23. The bonds market in Bangladesh is still in its infancy with only three listed bonds, two ofwhich are rated by CRISL and one by CRAB. In addition, there are some privately placed bondsand subordinated bonds that are under the rating fold. Six subordinated bonds issued bycommercial banks and 30 bonds (zero coupon, securitization, preference share, and debenture)issued by corporate firms through private placement were rated by CRAB. But unless and untilthe market for structured products is developed the scope of rating will remain limited.

B. Dhaka Stock Exchange Direct Listing Rules

24. The SECB initially allowed existing profitable and financially sound companies to sellsome of the shares owned by the owners through direct listing with the stock exchanges in

the hope that this would assist the companies in avoiding the lengthy process of IPO flotation.The preconditions for such direct listing, inter alia, included a condition that the company wouldcarry at least a BBB rating from a recognized rating agency.

25. On the basis of the above regulation, which came into play on 12 April 2006, five state-owned and five private companies were listed on the Dhaka Stock Exchange during the periodof 20062010.6 Eight of these companies were rated by CRISL and two others by CRAB. 7The state-owned companies were Desco, Power Grid, Jamuna Oil, Meghna Petroleum, andTitas Gas. The private companies were Shinepukur Ceramics, Khulna Power Company, OceanContainer, Navana CNG, and ACI Formulations.

26. This direct-listing method was strongly criticized as it was found to allow these firms to

charge exorbitant prices against their shares. In the wake of the share market crash in 2010, theregulation has since been revoked.

C. Banking Regulation and Policy Department, Bangladesh Bank, Circular Number 05Dated 29 May 2004 and Circular Number 06 Dated 13 March 2011

27. Bangladesh Banks Banking Regulation and Policy Department (BRPD) issued a circularon 29 May 2004 to all unlisted banking companies to get them rated before they proceeded forIPO. The banks that were waiting to go public at that time did opt for the rating exercise beforeproceeding. Six banks, namely, BRAC Bank, Jamuna Bank, Trust Bank, the Premier Bank,Shahjalal Islami Bank, and First Security Bank, were listed in the exchanges through IPO.8Three of these were rated by CRAB and the rest by CRISL.9In 2013, Bangladesh Bank granted

eight more banking licenses. Rating agencies forecast that in the near future these eight banksmay also be brought under the purview of annual rating.

4 Data sourced from www.dsebd.org

5 As mentioned by the CRAB Office Research and CRISL Management.

6 Data sourced from www.dsebd.org

7 As mentioned by the CRAB Office Research and CRISL Management.8 Data sourced from www.dsebd.org9 As mentioned by the CRAB Office Research and CRISL Management.


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28. The Insurance Development and Regulatory Authority (IDRA) is the primary regulatorof insurance companies in Bangladesh. Nevertheless, another circular issued by BangladeshBank, BRPD 06 dated 13 March 2011, made it mandatory for general insurance companies toget themselves rated. Through the circular, all banks were instructed to consider the rating ofgeneral insurance companies instead of the relationship-based enlistment of eligible insurancecompanies to provide insurance/cover note to the bank clients.

D. Guidelines of Bangladesh Bank for Capital Adequacy Framework andAccreditation of External Credit Assessment Institutions

29. Under the Capital Adequacy Framework for Commercial Banks under Basel II (whichwas adopted December 2007 and required full compliance by the banking sector in Bangladeshwithin January 2010), Bangladesh Bank has directed all commercial banks to nominaterecognized ECAIs to rate the banks as well as their counterparties. Due weight has been givenby ECAI ratings to capital adequacy. Unrated counterparties hence carry higher risk weight incapital adequacy determination, which works as an incentive to get the good clients rated.

30. As of 30 June 2013, Bangladesh Bank has recognized seven rating agencies as ECAIs:

Credit Rating Information and Services (CRISL) and Credit Rating Agency of Bangladesh(CRAB) in 2009; National Credit Ratings (NCRL) and Emerging Credit Rating (ECRL) in 2010;and ARGUS Credit Rating Services (ACRSL), Alpha Credit Rating (ACRL), and WASO CreditRating Company (BD) (WCRCL) in 2011 and 2012.

E. Circular of the Chief Controller of Insurance

31. The Circular of the Chief Controller of Insurance No. 21/21/98-376 dated 12 March 2007requires all general insurance companies to get rated once in a year and all life insurancecompanies, every 2 years, and also submit the rating report within 6 months of the completionof the financial year.10 As of December 2012, the number of insurance companies ratedby different rating agencies was 31 by CRAB, 23 by CRISL, 3 by ECRL, 2 by NCRL, and 2

by Alpha.11

32. Initially, the IDRA was proactive in ensuring universal implementation and all insurancecompanies were rated. In subsequent years, the emphasis was somewhat diluted, ratingagencies changed, and insurance companies slackened on renewal of rating. The outstandingratings of insurance companies by rating agency as of 30 August 2013 are 20 by CRISL, 13 byCRAB, 4 by Alpha, 2 by ECRL, and 1 by NCRL.12

33. The Parliament of Bangladesh passed two insurance laws on 3 March 2010 in a bid tostrengthen the regulatory framework and make the industry operationally vibrant. The new lawsthat came into effect on 18 March 2010 are the Insurance Act 2010 and IDRA 2010.The Insurance Act 2010 stated that the sector needs to be managed properly and then

strengthened by reducing business risks; local and international insurance laws need to bereconciled and aligned so that the interests of the policy holders and other beneficiaries areprotected.

10 The Chief Controller of Insurance is the erstwhile regulatory body for insurance companies in Bangladesh.

Insurance companies are presently regulated by the Insurance Development and Regulatory Authority ofBangladesh or the IDRA.

11 As mentioned by the CRAB Office Research.12

Data sourced from Dhaka Stock Exchange website. www.dsebd.org


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34. Based on the new legislation, the Office of Chief Controller of Insurance was dissolvedand the IDRA became the primary regulator of the insurance sector. As of December 2012,there are 62 insurance companies operating in the country, of which 43 general insurancecompanies and 17 life insurance companies belong to the private sector while only one generalinsurance company and one life insurance company belong to the public sector. All these firmsare regulated under the comprehensive laws and guidelines of the IDRA. In 2013, the IDRA has

approved 11 new insurance companies, of which two are general insurers while the remainingare life players. Ten out of these eleven already received licenses and the new insurers joinedwhat several observers say is already a crowded field.13

35. A circular for yearly mandatory ratings of insurers was also taken forward, which statedthat a life insurer was required to submit actuarial valuation reports on a yearly basis forthe distribution of dividends. Therefore, life insurance ratings are also expected to be mademandatory on an annual basis. In addition, licensing of new insurance companies alsoincreases the scale of insurance company ratings.

36. Like Bangladesh Bank, the IDRA is also planning to bring the rating agencies under itspurview of regulation and supervision. A set of guidelines is being developed at the IDRA, which

will have to be adhered to by credit rating companies that seek eligibility to conduct insurancesector rating, as well as minimum risk factors to be assessed for life and general insurancecredit rating.

V. PERFORMANCE OF DOMESTIC CREDIT RATING AGENCIES IN BANGLADESHWITH REFERENCE TO THE ADB HANDBOOK ON BEST PRACTICE COMPLIANCE

37. Of the seven DCRAs that have ECAI status in Bangladesh, CRISL, CRAB, NCRL, andECRL are members of ACRAA barring ACRSL, ACRL, and WCRCL, which have beenapproved by Bangladesh Bank very recently. According to the best practice compliance surveyconducted by the ACRAA Best Practice Committee in 2009, both CRISL and CRAB at this

stage broadly comply with the ADB Handbook on Best Practices for CRAs (though the defaultstatistics and transition metrics published by them are based on a small data pool).14

38. This is not surprising because CRISL was a founding member of ACRAA and itsphilosophy and methodology were developed around the practices established by its technicalpartners, initially DCR and later RAM. Credit Rating Agency of Bangladesh signed on to

ACRAA immediately after it was floated. It tends to emulate CRISL in terms of operationswith the technical support from ICRA. However, neither rating agency has the requisiteresearch division, criterion handling capacity, infrastructure, training, or database managementcapabilities in line with reputed CRAs such as CRISIL or ICRA in India or RAM, Malaysia. Thisis because CRISL and CRAB in Bangladesh are still fledgling businesses with limited financialresources and small capital bases.

39. The remaining DCRAs in Bangladesh are newly formed and have been catching up toadopt the best practice handbook of ADB.

13 Data sourced from the IDRA Office.14

ADB prepared a handbook on international best practice in credit rating in December 2008 (Appendix 1).


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40. The paid-up capital required for a DCRA to get a license in Bangladesh is Tk5.0 million,which is a meager amount compared with the size of operations of a DCRA. The capitalrequirement was fixed back in 1996 when there was no market of credit rating and there hasbeen a sea change in the market scenario in the meanwhile. As more new licenses are issued,DCRAs are faced with fierce competition among the existing agencies putting their sustainabilityunder a cloud. If rating agencies cannot sustain their business in the long run, there is an

inherent risk of deterioration in the quality of ratings.

41. Furthermore, considering the economic scenario, poor disclosure in financials, taxationrules, government policy, regulations of central bank, poor bond market, equity-based capitalmarket and above all, the newness and lack of understanding around credit rating, DCRAs inBangladesh need to walk an extra mile to ensure an unbiased and robust ratings process.Instead of relying entirely on audit reports to assess a client, in most of the cases, DCRAs arerequired to probe beyond the audited figures to reveal the true state of affairs. For example,suppose the audited financials reveal that a client has never earned any profit during the last10 years and capital is in the negative. Here the analyst in charge of the assessment needs toraise a flag on how and under what circumstances the client was able to pay all its loaninstallments in a timely fashion without a single instance of default. Such dichotomies need to

be identified, highlighted, and investigated before a rating report is released.

VI. CREDIT INFORMATION BUREAU VERSUS CREDIT RATING AGENCY

A. What Is a Credit Information Bureau?

42. A credit information bureau is an entity that provides the credit history of a borrower inthe form of a score based on various parameters. The main function of a credit informationbureau is to provide information about the creditworthiness of a borrower. The bureau should bein a position to provide a credit information report (CIR), which is a factual record of aborrowers credit payment history compiled on the basis of information received from various

credit institutions. Borrowers can also access their own credit report on payment of nominalfees. The bureaus functions include (among others) maintaining records of all credits, companyinformation, country data on various economic activities, and corporate profiling of borrowersthat access funds from lending institutions.

B. Credit Information Bureau in Bangladesh

43. Bangladesh Bank, on 18 August 1992, set up a division called the Credit InformationBureau (CIB), which compiles the records of borrowers financed by banks and financialinstitutions controlled and regulated by Bangladesh Bank. It is responsible for collecting,processing, and maintaining an updated database of credit-related information suppliedby borrowers for institutions that extend credit such as banks (Act 14, 1991), financial

institutions (Act 27, 1993), House Building Finance Corporation (Presidential Order 7, 1973),and Investment Corporation of Bangladesh (ICB Order 40, 1976).

44. One of the objectives of setting up the CIB was to provide timely credit information aboutloan applicants in response to requests from banks and financial institutions so as to expediteloan applications and minimize risk of default. Bangladesh Bank recently automated the CIBsystem such that credit information in the CIB database can be updated round the clock. Onlinecredit information is also available at the press of a button.


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45. The database of the CIB contains detailed information on credit granted by participants(banks and financial institutions) to individuals, institutions, and organizations. The word creditinformation stands for any information relating to (i) the amounts and the nature of loans oradvances and other credit facilities granted by a banking company to any borrower or class ofborrowers, (ii) the nature of security taken from any borrower for credit facilities granted to himor her, and (iii) the guarantee furnished by a banking company for any of its customers.

C. Regulatory Framework for the Credit Information Bureau in Bangladesh

46. The CIB is authorized to collect and provide data to financial institutions through astipulation in Chapter IV on Collection and Furnishing of Credit Information of the BangladeshBank Order 1972, as amended.

47. Lending institutions are mandated to periodically report lending records by borrower inprescribed formats to the bureau. Before any loan is granted or renewed, the lending institutionis supposed to compulsorily refer to the borrowers CIR from the central banks creditinformation division, which will indicate if the borrower has ever defaulted on or is currently indefault with any other bank or NBFI. The CIR is not in the public domain and is available for

reference only to banks and financial institutions under Bangladesh Bank.

48. Bangladesh Bank does not have any separate regulatory framework for the CIB in itspresent form as it operates as a division within the central bank. Existing regulations ofBangladesh Bank do not permit borrowers to access their own credit data but there is a clearprocess that enables borrowers to challenge incorrect information through their lenders. Withinthe legal framework that governs the CIB, the following principles are of paramount importance:(i) all participants (banks/financial institutions) are obliged to inform the CIB of their clientsliabilities, (ii) the handling and circulation of individual information on a borrower is confidential,(iii) all participants have access to the information on a reciprocal basis, and (iv) all theborrowers have the right to request any participant (bank/financial institution) to rectify or updatethe liabilities.

49. While financial institutions are statutorily required to provide loan data, includinginformation on collateral and guarantees to Bangladesh Bank, giving banks and financialinstitutions access to the total liabilities of each borrower in the CIB database, there are limitsimposed on information that the central bank can further share with other lenders. Thus,although the information that there is a classified loan can be made available, the lending bankholding this classified loan cannot be identified.

50. It may be possible for a new borrower or organization to get a loan even thoughinformation related to it is not available in the CIB database. If information on individuals ororganizations is available on the CIB database, this by itself poses no obstacle to getting a loansanctioned. A loan stems from an agreement between the client and the bank/financial

institution.

51. Any instance of default in the credit history of a borrower immediately debars it fromfurther loans from any financial institution under Sections 27 KaKa and 5 GaGa of the BankCompany Act 1991 (Amended). Unless the default loan is adjusted, rescheduled, or declassifiedthe borrower in question remains ineligible for loans or extensions on loans.


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D. Credit Information Bureau versus Credit Rating Agencies

52. As mentioned earlier, Bangladesh Bank does not have a separate regulatory frameworkfor the CIB in its present form as it operates as a division within the central bank.

53. On the contrary, DCRAs in Bangladesh are regulated by the SECB through CRC

Rules 1996.

54. The CIR neither expresses any opinion about the borrowers creditworthiness norassigns any rating to the borrowers. It provides only the factual position of borrowers creditexposure as of a certain date presenting data of repayment of principle and interest based onpast record. It also reports on the classification status of the borrower. The CIB does not haveany data on a borrowers business operation.

55. Rating agencies on the contrary are required to maintain a database on the variouseconomic sectors and corporate entities within each sector, particularly in the context of timelyrepayment of obligations. The database covers information on business operations, turnover,profitability, assets and liabilities, liquidity, long-term financing pattern, debt equity, and business

prospects. The information is far more exhaustive than that presented in a CIR on credit historyonly. Rating agencies periodically update sector-specific data to determine sector-wiseprofitability, financing patterns, etc. This information is essential to rate a counterparty takingloan from any financial institution.

56. Credit ratings, thus, express an independent and objective opinion on the ability andwillingness of an issuer to meet its financial obligations in accordance with credit terms of theinitial contract. Instrument credit rating is an opinion on the probability that an issuer of a ratedissue will pay interest and principal on time. Each rating category has a non-zero probability ofdefault, including the highest one. Probability of default of a rating band may fluctuate over timeon account of economic cycles and changes in risk profile of the relevant sector. Ratings aredesigned to be forward looking, even though groundwork analysis for credit ratings entails an

appraisal of historical data. Thus ratings take into account the potential impact of future eventson the issuers repayment ability.

VII. IMPLEMENTING THE BASEL II GUIDELINES OF CAPITAL ADEQUACYFRAMEWORK FOR COMMERCIAL BANKS AND THE ROLE OFDOMESTIC CREDIT RATING AGENCIES

57. Bangladesh Bank, in line with international practice, issued a circular on 30 December2007 towards the adoption of the Basel II Guidelines of Capital Adequacy Framework forCommercial Banks.15 Accordingly, Bangladesh Bank adopted the following implementationstrategy:

(i) standardized approachfor calculating Risk Weighted Amount (RWA) against creditrisksupported by ECAIs,

(ii) standardized rule based approachagainst market risk, and(iii) basic indicator approachfor operational risk.

15 BRPD Circular No. 14, 30 December 2007.


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58. In order to implement the above, Bangladesh Bank issued a road map which has beenpresented in Table 1.16

Table 1: Road Map for Implementing the BASEL II Capital Adequacy Frameworkin Commercial Banks

Step of Activity/Action DescriptionLast Date of

Completing the Task

1 Fixing rules for recognition ofExternal Credit AssessmentInstitutions (ECAIs)

Developing guidelines forrecognition of ECAIs

31 March 2008

2 Consultation with stakeholdersand issuing a circular onrecognition of ratings by ECAIsand mapping of ratings with theappropriate risk weights

Final approval of ECAI guidelines 31 May 2008

3 Preparation of draft guidelines forBasel II implementation

Preparation of draft guidelineswith reporting format andpublishing/circulating the same for

appraisal of stakeholders

31 August 2008

4 Issuance of circular on regulationfor compliance of Basel II alongwith final guidelines andreporting format

Issuing detailed instructions tobanks for implementation of Basel IIand reporting the same toBangladesh Bank regularly

31 December 2008

5 Parallel run of present regulation(Basel I) on Capital Adequacyand Basel II Accord

Banks to continue calculation ofminimum capital requirement(MCR) as per existing regulationand simultaneous calculation ofMCR under Basel II

1 January 200931 December 2009

6 Developing database forswitching to Internal Rating BasedApproach (IRBA)

For calculating MCR under IRBA,banks will derive the figure fordetermining the probability ofdefault on the basis of its own

database and seek figure on lossgiven to default, exposure atdefault, and maturity of creditexposure from Bangladesh Bank.Thus, Bangladesh Bank willdevelop and maintain the requiredloss database to meet therequirements and banks will beprepared in this regard.

By 2012

7 Migration to IRBA(Bangladesh Banks priorapproval needed)

Foundation IRBA both at the levelof Bangladesh Bank and otherbanks run in parallel along with thestandardized approach

By 2012

59. The central bank has broadly succeeded in adhering to the time schedule above.Bangladesh Bank issued the Basel II Capital Adequacy Circular entitled Guidelines onRisk Based Capital Adequacy (RBCA) for Banks (Revised Regulatory Capital Frameworkin line with Basel II) on 31 December 2008 parallel to the existing BRPD Circular No. 10, dated25 November 2002, which is basically introducing the requirement of Basel I.17

16 Ibid.17

Revised Capital Adequacy Guidelines dated 10 August 2010.


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60. At the end of a parallel run, the Basel II regime came into force and the guidelines onRBCA were fully implemented from 1 January 2010 onwards with subsequent supplements andrevisions. Instructions regarding minimum capital requirement (MCR) that scheduled banksneeded to follow, along with the instructions contained in the revised guidelines on risk basedcapital adequacy for banks, were articulated with the following areas:

(i) introduction and constituents of capital,(ii) credit risk,(iii) market risk,(iv) operational risk,(v) supervisory review process,(vi) supervisory review evaluation process,(vii) market discipline,(viii) reporting formats, and(ix) annexure.

A. Status of External Credit Assessment Institutions

61. Under the standardized approach of the Risk Based Capital Adequacy Framework(Basel II), credit rating is determined on the basis of the risk profile assessed by the ECAIsrecognized by Bangladesh Bank. All scheduled banks have been asked to nominate arecognized ECAI for their own credit rating as well as that of their counterparty. In thisperspective, a set of guidelines regarding the recognition of eligible ECAIs was issued andforwarded to the scheduled banks. The Bangladesh Bank circular says, External Credit

Assessment Institutions duly recognized by Bangladesh Bank will be engaged in credit riskassessment under the standardized approach of the Risk Based Capital Adequacy Framework(Basel II).18On the basis of that assessment, risk weight will be mapped with the credit ratingcategory and the risk weighted assets will be determined for calculating the capital requirementof banks against credit risk. The criteria of ECAI recognition and mapping process of risk weighthas been developed in line with the International Convergence of Capital Measurement and

Capital Standards (Basel II) issued by the Basel Committee on Banking Supervision (BCBS) inJune 2006. The recognition criteria have been listed below.

(i) Objectivity. The methodology for assigning credit assessments must be rigorous,systematic, and subject to validation based on historical experience. Moreover,assessments must be subject to ongoing review and responsive to changes in thefinancial condition of the concerned entity. An assessment methodology for eachmarket segment, including rigorous back-testing, must be established for at least1 year and preferably 3 years.

(ii) Independence. An ECAI should be independent and free from political, social, oreconomic pressure that may influence the rating. The assessment process should alsobe free from any such constraint that could arise in situations where the composition of

the board of directors or the shareholder structure and the officials of the assessmentteam of the ECAIs may be seen to create a conflict of interest.

(iii) International access and transparency. The individual assessment should beavailable to both domestic and foreign institutions with legitimate interests, and atequivalent terms. In addition, the rating methodology used by the ECAI should bepublicly available.

18 BRPD Circular No. 09, dated 31 December 2008.


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(iv) Disclosure.An ECAI should disclose its assessment methodologies, notch or notationused, definition of the default rating category, the meaning of each rating and its timehorizon, actual default rates experienced in each assessment category, and thetransitions of the assessment, e.g., the likelihood of AA ratings becoming A over time.

(v) Resources.An ECAI should have sufficient resources to carry out high-quality creditassessment. These resources should allow for substantial ongoing contact with

executives at both senior and operational levels within the rated entities in order to addvalue to the credit assessments. Such assessment methodologies should be based onboth qualitative and quantitative approaches.

(vi) Credibility. In addition to the above criteria, reliance on the credit assessment byindependent parties (investors, insurers, trading partners) shall provide evidenceof the credibility of the assessment of an ECAI. The credibility of an ECAI is alsounderpinned by the existence of effective internal control to prevent the misuse ofconfidential information.

B. Monitoring and Mapping the Rating Quality of External CreditAssessment Institutions

62. In order to monitor the quality of rating, Bangladesh Bank has devised a process ofmapping ECAI ratings against those of Standard & Poors (S&P) and Moodys along with theBangladesh Bank risk weight category (Table 2).

63. In order to comply with the principles of objectivity and consistency, quantitative dataform the basis of the mapping process. Quantitative factors include long-term default rateassociated with items that are assigned the same credit assessment.

64. Bangladesh Bank has mapped risk weight to the ECAIs rating categoriesdecidingwhich rating categories correspond to Bangladesh Banks corresponding risk weights category.Bangladesh Bank, in its BRPD Circular No. 05 dated 29 April 2009, circulated its firstmapping of CRISL and CRAB ratings with Bangladesh Bank rating grade. The mapping of

rating scales of six rating agencies with Bangladesh Bank rating grades has been revised withsome modification and circulated, in its BRPD Circular No. 35 dated 29 December 2010, andsubsequent inclusions are given in Table 2.

65. An ECAI rating has been mapped on grades 1 to 6, with 1 being the best and 6 beingthe worst and includes the Default Rating Category. Each short-term credit rating categorycan be evaluated and mapped against categories S1 to S6, with S1 being the best. BangladeshBank assigns risk weights on the basis of the evaluation of a variety of qualitative andquantitative factors relate to ECAIs rating category.

66. The consistency of an ECAIs rating category is determined through an analysis of thecumulative default rate (CDR) which is the measure of movement of a rating category into

default rating during a specific time period.19

The indicators considered are

(i) 10-year average of the 3-year CDR for evaluating the long-run default experience, and(ii) most recent 3-year CDR for evaluating the short-run default experience.

19 The definition of default rating has an impact on the assessment of CDR. External credit assessment institutions

are expected to declare the definition of default rating on their websites and submit a copy to Bangladesh Bank.Subsequently, if any amendment on the same is made, it must be reported to Bangladesh Bank with duejustification thereof.


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67. The use of 3-year CDRs, evaluated over the longer term, and on an ongoing basis, isconsidered to provide an appropriate measure of the predictive power of credit assessments inrelation to creditworthiness.

Table 2: Mapping of Bangladesh Banks Rating Grade with Rating Scales

Long-Term Rating Category Mapping

BangladeshBanksRatingGrade

EquivalentRating ofS&PandFitch

EquivalentRating ofMoody's

EquivalentNotch/

Notation ofCRISL

EquivalentNotch/

Notation ofCRAB

EquivalentNotch/

Notationof NCRL

EquivalentNotch/

Notationof ECRL

EquivalentNotch/

Notation ofACRSL

EquivalentNotch/

Notation ofACRL

1 AAA toAA

Aaa to Aa AAA AAA AAA AAA AAA AAA

AA+, AA,AA

AA1, AA2,AA3

AA+, AA,AA

AA+, AA,AA

AA+, AA,AA

AA+, AA,AA

2 A A A+, A, A A1, A2, A3 A+, A, A A+, A, A A+, A, A A+, A, A

3 BBB Baa BBB+, BBB,BBB

BBB1,BBB2,BBB3

BBB+,BBB,BBB

BBB+,BBB,BBB

BBB+,BBB,BBB

BBB+,BBB,BBB

4 BB to B Ba to B BB+, BB,BB

BB1, BB2,BB3

BB+, BB,BB

BB+, BB,BB

BB+, BB,BB

BB+, BB,BB

5 Below B Below B B+, B, BCCC+, CCC,

CCCCC+, CC,

CC

B1, B2, B3CCC1,CCC2,CCC3CC

B+, B, B B+, B, B B+, B, BCC+, CC,

CC

B+, B, B,CCC

6 C+, C,C, D

C, D C+, C,C, D

C, D C+, C,C, D

CC+, CC,CC, C+,C, C, D

Short-Term Rating Category Mapping

S1 F1+ P1 ST-1 ST-1 N1 ECRL-1 ST-1 AR-1

S2 F1 P2 ST-2 ST-2 N2 ECRL-2 ST-2 AR-2

S3 F2 P3 ST-3 ST-3 N3 ECRL-3 ST-3 AR-3

S4 F3 NP ST-4 ST-4 N4 ECRL-4 ST-4 AR-4

S5, S6 B, C, D ST-5, ST-6 ST-5, ST-6 N5 D ST-5, ST-6 AR-5, AR-6

ACRL = Alpha Credit Rating, ACRSL = ARGUS Credit Rating Services, CRAB = Credit Rating Agency of Bangladesh, CRISL = CreditRating Information and Services, ECRL = Emerging Credit Rating, NCRL = National Credit Ratings, S&P = Standard & Poors.

68. Using the data provided by the ECAI, competent authorities will compare the mostrecent 10-year average of the 3-year CDR with the proposed long-run reference 3-year CDRs(Table 3).20 In general terms, the approach to mapping set out in the guidance provided bythe Basel Committee is considered to represent the appropriate basis for mapping underthese guidelines. It incorporates the use of 3-year CDRs together with qualitative analysis andappropriate flexibility of supervisory response.

Table 3: Long-Run Reference 3-Year Cumulative Default Rate

Standard & Poors assessment AAAAA A BBB BB B

Moodys AaaAa A Baa Ba B

20 years average 3-year cumulative default rate 0.10% 0.25% 1.00% 7.5% 20.00%

20 It should be noted that the numbers provided for the long-term benchmarks are mid-point numbers. Consequently,supervisory authorities will not expect the data provided by ECAIs to coincide exactly with these numbers.


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69. The transition of an individual notch towards the default rating category observed in aparticular ECAI rating category is compared with the standards available domestically,regionally, and internationally. Long-run transition towards default category of the ECAIs ratingswill be compared with the reference values of CDRs available domestically, regionally, andinternationally. In this connection, internationally accepted long-run reference values have beenaccepted by Bangladesh Bank.

70. Bangladesh Bank will use two benchmark CDRs, namely the monitoring level CDR andthe trigger level CDR, for interpreting whether a CDR falls within an acceptable range for arating category (Table 4).

Table 4: Three-Year Cumulative Default Rate Benchmark

Standard & Poors assessment AAAAA A BBB BB B

Moodys AaaAa A Baa Ba B

Monitoring level 0.8% 1.0% 2.4% 11.0% 28.6%

Trigger level 1.2% 1.3% 3.0% 12.4% 35.0%

71. Exceeding the monitoring level CDR benchmark implies that a rating agencystransition to default rating for a particular notch or notation is markedly higher than the domestic,regional, and international transition experience to default rating. A consultation process withthe relevant ECAI will commence to understand why the default experience appears to besignificantly worse. If Bangladesh Bank determines that the higher default experience isattributable to weaker standards in assessing credit risk, it would be expected to assign a higherrisk category to ECAIs credit risk assessments.

72. Exceeding the trigger level benchmark implies that transition of an ECAIs notch ornotation towards a default rating is considerably above the domestic, regional, and international

standards. If the observed 3-year CDR exceeds the trigger level in 2 consecutive years, theECAIs rating category shall be degraded.

73. External credit assessment institutions that have only a short record of transition anddefault data will be required to provide a projection of the 10-year average of the 3-year CDR onthe basis of the two most recent CDRs.

74. Additionally, qualitative factors are also used by Bangladesh Bank to ensurecomparability across data provided by different ECAIs. Qualitative factors consist ofconsiderations such as the methodologies adopted by ECAIs, the pool of issuers that theECAI covers, the range of transactions assessed, the meaning of each credit assessment, andthe ECAIs definition of default. These parameters are important in the analysis of the transition

and default data submitted by the ECAIs and the assessment of their performance againstbenchmarks. Where quantitative data is inconclusive for mapping risk weights, qualitativecriteria may be the only basis.


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assets remains unchanged across Basel I and II, with the implementation of Basel II, the capitaladequacy ratio (CAR) for most banks fell by at least 3%, and unrated clients have contributedsignificantly towards this reduction.

79. In India, mandatory provision of 150% risk weight for unrated clients has ensured thatrating agencies recognized as ECAI contribute significantly to the economymost of the clients

are now rated and the surveillance of ratings continues to provide a bank the comfort of riskcategorization in its own portfolio. On the contrary, in Pakistan there has been no significantimpact on Basel II implementation since the unrated clients are still assigned a 100% risk weightas was the practice under Basel I.

80. With 125% risk weight assigned to unrated private lending in Bangladesh (a moderateapproach that lies between Pakistans 100% and Indias 150%), the banks are now seriouslypersuading and incentivizing clients, especially good clients, to opt for rating.

81. Bangladesh Bank has clearly entered the Basel II regime and ECAI ratings can beexpected to continue to play a positive role in risk categorization of bank portfolios.

D. Basel II Implementation: Bankers Challenges in Credit Risk Rating

82. Bangladesh Bank, in its Circular No. 9 dated 31 December 2008, instructed allcommercial banks to maintain capital adequacy under Basel II after a parallel run of 1 year.The primary purpose is to ensure that banks henceforth maintain capital adequacy against not

just credit risk but also operational and market risk. Banks are asked to calculate the credit riskon the basis of the credit rating assigned by ECAIs and by mapping the rating againstBangladesh Banks risk weights both in the case of long-term as well as short-term ratings.Unrated clients attract a fixed risk weight of 125%.

83. In implementing the Basel II framework for capital adequacy, bankers in Bangladeshwere faced with the following challenges:

(i) Since most of the banks were operating at the minimum capital level to begin with,additional capital required to cover market and operational risks was hard to come by,thus pushing the CAR below the minimum acceptable level.

(ii) Since almost all clients in the portfolio were unrated, risk weights across the boardincreased from 100% (under Basel I) to 125%.

(iii) Most state-owned commercial banks provided finance to the (generally unrated) publicsector entities, which now attracted a 50% risk weight under Basel II as opposed to20% under Basel I.

(iv) Clients were not interested in opting for rating and banks lived in the fear of losingloyal clients.

84. In view of the fact that, with Basel II, the overall CAR has decreased by 3.0%3.5%across banks and bankers are unable to cope in the short run, the regulators have temporarilyreduced the capital adequacy requirement from 10% of all risk weighted assets to 8% with theunderstanding that banks will be able to convince their clients to get themselves rated. It isexpected that within a 2-year period, it will be possible to reinstate the capital adequacy normof 10% without all banks going under. In this context, some private sector banks have beenvigorously trying to get their clients rated in the shortest possible time.


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85. Banks that are now convinced of the importance of rating view it as a tool that enablesnew/further financing. They are starting to reap other advantages of servicing rated clients aswell. Rating gives the banks insight into the financial health of the clients. They are betterinformed about the sectors they are financing. Ongoing or renewed rating reports are importantwhen applications for further financing are assessed. During January 2011November 2011,banks therefore have been actively encouraging their clients to get rated.

86. Notwithstanding the clear advantages of rating mentioned above, bankers that havesucceeded in persuading a larger number of clients to get rated, are still not getting desiredresults in terms of capital adequacy. This is despite the fact that the ratings being assigned tothe clients by the ECAIs are more or less in line with the banks perception of the clientscreditworthiness. The reason for this lies in the flawed mapping of ECAI ratings on theBangladesh Bank risk-rating scales in the long term (Table 6).21

Table 6: Mapping the Ratings of Credit Rating Information and Services andCredit Rating Agency of Bangladesh on the Bangladesh Bank Rating Grade

Bangladesh BankRating Grade Risk Weight % Equivalent Rating of CRISL Equivalent Rating of CRAB

1 20 AAA AAA

2 50 AA+, AA AA1, AA2

3 50/100a AA, A+, A, A AA3, A1, A2

4 100 BBB+, BBB, BBB BBB1, BBB2, BBB3

5 100/150 BB+, BB, BB, B+B, BCCC+,CCC, CCC, and below

BB1, BB2, BB3, CCC1, CCC2

6 150 CC+ and below CCC3 and below

Short-Term Rating Category Mapping

S1 20 ST-1 ST-1

S2 50 ST-2 ST-2

S3 50 ST-3 ST-3

S4 100 ST-4 ST-4S5 100 ST-5 ST-5

S6 150 ST-6 ST-6

CRAB = Credit Rating Agency of Bangladesh, CRISL = Credit Rating Information and Services.Notes:a 50 for banks and 100 for corporates.

b 100 for banks and 150 for corporates.

87. It is observed from Table 6 that all ratings ranging from AA (implying high safety) toBBB (implying the low end of moderate safety) are lumped in the same risk categorybanksare dragged down by the weight if even the relatively good A-rated clients are mapped with a100% risk weight. In both the rating scale of CRISL and CRAB, risk levels in the rating scale

AA/AA3 to BBB/BBB3 display wide variations.

88. It is observed from Table 6 that the initial mapping of Bangladesh Banks risk weight onthe ECAI rating places AA/AA3 (means high safety) to BBB/BBB3 (means lower of moderatesafety) in the same risk category.

21 BRPD Circular No. 5, dated 29 April 2009.


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89. If one were to compare Tables 5 and 6 to Table 7, some significant aspects arerevealed:

(i) Grade 3 enterprises on the Bangladesh Banks risk scale attract a risk weight of 100%if they are corporate firms and 50% if they are PSEs or banks. In fact AA (high safety)and A+, A, A (adequate safety) ratings fall within Grade 3. On the contrary in the

original Basel document, AA ratings carries 20% risk weight while A ratings carry 50%risk weight.

(ii) Grade 5 enterprises on the Bangladesh Banks risk scale which attract a risk weight of150% if they are corporate firms and 100% if they are public sector entities (PSEs) orbanks. In the Basel document, these are mandated to carry 100% risk weight.

(iii) The Basel document suggests a 50% risk weight for all A-rated enterprises whereasBangladesh Bank places only AA+ and AA under 50% risk weight category

(iv) As a consequence, some high safety rating grades (say AA) are merged withmoderate safety categories, burdening the lenders with huge risk weights that erodetheir capital adequacy.

90. To address the above drawbacks, Bangladesh Bank revised its mapping scale through

BRPD Circular No. 35 dated 29 December 2010 (Table 7).

Table 7: Revised Mapping of Bangladesh Banks Rating Grade with Rating Scales

Risk Weights for Long-Term Rating Category

BangladeshBanks Rating

Grade

RiskWeight

(%)

EquivalentNotch/

Notation ofCRISL

EquivalentNotch/

Notation ofCRAB

EquivalentNotch/

Notation ofNCRL

EquivalentNotch/

Notation ofECRL

EquivalentNotch/

Notation ofACRSL

EquivalentNotch/

Notation ofACRL

1 20 AAA AAA AAA AAA AAA AAA

AA+, AA, AA- AA1, AA2, AA3 AA+, AA, AA AA+, AA,AA

AA+, AA,AA

AA+, AA, AA

2 50 A+, A, A A1, A2, A3 A+, A, A A+, A, A A+, A, A A+, A, A

3 100/50a BBB+, BBB,BBB

BBB1, BBB2,BBB3

BBB+, BBB,BBB

BBB+, BBB,BBB

BBB+,BBB, BBB

BBB+, BBB,BBB

4 100 BB+, BB, BB BB1, BB2, BB3 BB+, BB, BB BB+, BB,BB

BB+, BB,BB

BB+, BB, BB

5 150/100b B+, B, BCCC+, CCC,

CCCCC+, CC, CC

B1, B2, B3CCC1, CCC2,

CCC3CC

B+, B, B B+, B, B B+, B, BCC+, CC,

CC

B+, B, B, CCC

6 C+, C, C, D C, D C+, C, C, D C, D C+, C, C,D

CC+, CC, CC,C+, C, C, D

Risk Weights for Short-Term Rating Category

S1 20 ST-1 ST-1 N1 ECRL-1 ST-1 AR-1



S4 100 ST-4 ST-4 N4 ECRL-4 ST-4 AR-4

S5, S6 150 ST-5, ST-6 ST-5, ST-6 N5 D ST-5, ST-6 AR-5, AR-6

ACRL = Alpha Credit Rating, ACRSL = ARGUS Credit Rating Services, CRAB = Credit Rating Agency of Bangladesh,CRISL = Credit Rating Information and Services, ECRL = Emerging Credit Rating, NCRL = National Credit Ratings.Notes:a 50% for banks and 100% for corporates.b 100% for banks and 150% for corporates; 125% for unrated corporates.


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91. The key changes in revised mapping (29 December 2010) over the initial mapping(29 April 2009) are as follows:

(i) AAA and AA rating bands are placed in the Bangladesh Bank Grade 1 bucket whichwill attract same risk weight, i.e., 20%. Previously AA was partially categorized in the50% risk weight bucket.

(ii) A rating band is categorized Bangladesh Bank Grade 2 which will now attract 50%risk weight instead of 100% which was the case earlier.

(iii) BBB rating band has been upgraded to Bangladesh Bank Grade 3 but risk weightremains 100% for corporate firms.

(iv) BB rating band has been upgraded to Bangladesh Bank Grade 4 from Grade 5,therefore the risk weight for a BB rating has changed to 100% from 150%. This is amajor change.

92. As a consequence of the above changes, many banks were motivated to take initiativeto rate their clients. As of October 2012, around 4,500 clients have been brought under thepurview of ratings.

93. In Table 8, numbers of ratings and rating history of six rating agencies as of December2012 are depicted:

Table 8: Number of Ratings by Rating Agency

Number of Ratingsin 2012

a

Number of Ratingsince Inception toDecember 2012

b

S. no.Rating Agency

(Year of Inception)No. of

Ratings %No. of

Ratings % Up to

1 CRAB (2004) 1,314 63 2,680 48 31 December2012

2 CRISL (2002) 310 15 1,988 36 14 November

20123 ECRL (2011) 293 14 396 7 5 November

2012

4 NCRL(2011) 160 8 493 9 30 September2012

5 ACRSL (2011) n.a. n.a. n.a. n.a.

6 ACRL (2012) n.a. n.a. n.a. n.a.

Total 2,077 100 5,557 100

n.a. = data not available, ACRL = Alpha Credit Rating, ACRSL = ARGUS Credit Rating Services, CRAB = Credit Rating Agency ofBangladesh, CRISL = Credit Rating Information and Services, ECRL Emerging Credit Rating, NCRL = National Credit Ratings.a The ratings conducted only in 2012 by the respective rating agencies and their shares in percentages are shown.

b The ratings conducted by the respective rating agencies since their inception (cumulative) and their shares in percentagesare shown.


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94. In Tables 9, 10, and 11, long-term ratings assigned only in 2012 by the respective ratingagencies are presented:

Table 9: Distribution of Ratings in 2012 by Long-Term Rating Notch

Long-Term Rating Notch CRAB CRISL NCRL ECRLAAA 3 4 0 3

AA 87 20 4 10

A 151 98 69 33

BBB 325 164 56 199

BB 260 11 8 27

B 31 2 0 1

CCCD 2 0 0 0

Total 859 299 137 273

CRAB = Credit Rating Agency of Bangladesh, CRISL = Credit Rating Information and Services, ECRL Emerging Credit Rating,NCRL = National Credit Ratings.

Table 10: Distribution of Ratings in 2012 in Percentages

Long-Term Rating Notch CRAB(%) CRISL(%) NCRL(%) ECRL(%)

AAA 0.35 1.34 0.00 1.10

AA 10.13 6.69 2.92 3.66

A 17.58 32.78 50.36 12.09

BBB 37.83 54.85 40.88 72.89

BB 30.27 3.68 5.84 9.89

B 3.61 0.67 0.00 0.37

CCCD 0.23 0.00 0.00 0.00

Total 100.00 100.00 100.00 100.00

CRAB = Credit Rating Agency of Bangladesh, CRISL = Credit Rating Information and Services, ECRL = Emerging Credit Rating,NCRL = National Credit Ratings.

Table 11: Distribution of Ratings in 2012 by Investment Grade Category

Category CRAB(%) CRISL(%) NCRL(%) ECRL(%)

Investment Grade(From AAA to BBB)

65.89 95.65 94.16 89.74

Non-Investment Grade(From BB to D)

34.11 4.35 5.84 10.26

Total 100.00 100.00 100.00 100.00

CRAB = Credit Rating Agency of Bangladesh, CRISL = Credit Rating Information and Services, ECRL = Emerging Credit Rating,NCRL = National Credit Ratings.

95. A report published by CRAB indicates a median CAR figure in the fiscal year 2011 was11.40%, which is higher than its temporal requirement of 8% and its permanent requirementof 10%.22 In the fiscal year 2012, CAR was 10.05%, compared with 12.5% in the fiscal year2009. The figure in 2009 was moderately high as Basel II was introduced in Bangladesh in

22CRAB. 2012. The Bangladesh Banking Industry Performance Review of Private Commercial BanksFY2011.Dhaka: Credit Rating Agency of Bangladesh.


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20092010 and it ran parallel with Basel I. Due to new guidelines released in 2010, the overallcapital adequacy level dropped; however, that year the banks managed to maintain their CARfully under the Basel II framework.

VIII. INTERNAL CREDIT RATINGS BY COMMERCIAL BANKS IN BANGLADESH

96. As of 31 December 2012, there were 47 commercial banks functioning in Bangladesh.In 2013, eight more banksNon-resident Bangladeshi (NRB) Commercial Bank, NRB Bank,Union Bank (Islami Shariah-based bank), South Bangla Agricultural Bank and Meghna Bank,Midland Bank, Farmers Bank, and NRB Global Bankreceived licenses from the central bankbringing the total number of scheduled banks to 55 (Table 12).

Table 12: Banking Sector in Bangladesh

Nature of Banks No. of Banks

State-owned commercial banks (SCBs) 4

Private commercial banks (PCBs) 30Islami Shariah-based PCBs 8

Foreign commercial banks (FCBs) 9

Specialized banks (SBs) 4

Total 55

Source: Bangladesh Bank.

97. In the past, commercial banks in Bangladesh used to, by and large, lend to clientswho had an established history of reliability and perceived credibility without any systematicobjective evaluation of their credit standing. Bangladesh Bank introduced lending risk analysis(LRA) in 1993 as part of banking sector reform, which was replaced by the more comprehensive

Credit Risk Grading Model (CRGM) in 2005. In this context, Bangladesh Bank circulated aformat for assigning weights to financial risk, management risk, industry risk, business risk, andbanking relationship risk. In practice, however, it has been observed that CRGM is not followedproperly. Banks still work with principles of targeted lending where the traditional methods offace-lending take precedence over CRG, which is relegated to the status of a formality thatmust be completed in order to fill the forms.

98. Furthermore, with the exception of a few high investment grade foreign banks, none ofthe other banking institutions appear to have the capability to undertake internal credit rating.While Bangladesh Bank had been pushing for the adoption of IRBA by 2012, this was notrealistic. Even in cases where banks are capital surplus, they are more likely to utilize the capitalcushion to invite profitable clients to borrow (even at reduced interest rates) than to incur thelarge costs of implementing IRBA.

99. One of the preconditions to implementing IRBA is a robust IT platform, required tomaintain the customer database for at least 5 years. First, banks in Bangladesh, in general,do not have such sophisticated IT systems. While some have installed IT systems in the recentpast, these are yet to be aligned with IRBA compliance needs. Second, there is a seriousscarcity of trained personnel who are not only IT-skilled but also have a thorough understandingof the ramifications of maintaining an IT superstructure to serve IRBA requirements. So ITtraining needs to be backed up by strong banking knowledge, which is a combination tough to


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X. BANGLADESH BANKS MOVE TOWARD RATING SMALL ANDMEDIUM-SIZED ENTERPRISES

102. To enable the development of small and medium-sized enterprises (SMEs) in thecountry and encourage greater transparency and credit discipline, Bangladesh Bank proposesto launch SME ratings in Bangladesh. SMEs have several unique characteristics that warrant

a customized credit assessment framework and methodology as well as separate ratingscale and symbol. Unlike the corporate, the SME sector has no organized information onindustries, market shares, competition dynamics, and promoter or management track records.The creditworthiness of SME units, therefore, needs to be assessed using tools and methodsthat are different from those traditionally used for corporate firms.

103. Bangladesh Bank is at the final stage of introducing a common methodology forrecognized DCRAs to evaluate SMEs under its proposed rule on Capital Adequacy Policy forSMEs under Basel II Principles. Bangladesh Bank formed an internal working group on ECAIrecognition in order to set eligibility criteria for ECAIs

(i) to be qualified to rate SMEs;

(ii) to develop a standard SME rating methodology to be followed by ECAIs (minimum riskfactors to be assessed for SME credit rating);

(iii) to develop a scoring system, a set of notches and symbols that are appropriate forSMEs (distinct from those for corporate firms), and the mapping of these scoresagainst the rating grades of Bangladesh Bank; and

(iv) to devise appropriate risk weight for each rating category.

104. An elaborate description of credit rating system development for SMEs in Bangladesh islaid down in Appendix 2 of this report.

105. Industrial Policy 2010 and accordingly Circular No. 1 dated 19 June 2011 of theSmall and Medium Enterprises Special Programs Department (SMESPD) of Bangladesh Bank

defines SMEs in terms of the value of fixed assets with replacement cost excluding land andbuilding or in terms of the number of persons employed (Table 13).

Table 13: Categorization of Small and Medium-sized Enterprises in Bangladesh

Category Industry TypeValue of Fixed Assets

(Tk million)Number of Persons

Employed

Medium Manufacturing 100300 100250

Service/Trading 10150 1025

Small Manufacturing 5100 2599

Service/Trading 0.510 1025

106. Bangladesh Banks draft document on SME rating methodology stipulates in theparagraph entitled Objectives of SME Rating that banks and financial institutions aremigrating from an opinion-based credit review process of an individual towards a systematicand scientific process with an emphasis on objective inputs. The need for faster, more accurate,uniform, and timely credit decisions is cited as main reason for this shift. The deployment


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of highly productive and easy-to-use tools in decision-making could be an effective solution.The objectives of SME ratings are

(i) compliance with standardized approach of Basel II requirements;(ii) creation of risk rating system;(iii) help to automate credit origination, credit approval process, risk administration, and

monitoring functions and management of non-performing assets; and(iv) help to provide data feeds for management reporting.

XI. CONCLUSIONS

107. Credit rating is comparatively new in Bangladesh although SECB framed the regulationsfor it way back in 1996. The banking and business community in Bangladesh is gradually gettingfamiliar with the concept as Basel II is being unrolled. Bankers are showing keenness tomigrate from CRGM into making investments based on counterparty rating, a development thatcan improve the prospects of the rating industry by compelling it to act responsibly and conductits business ethically. Even counterparties are depending more and more on rating reports to

identify operational drawbacks or lacunae that would have hitherto been overlooked due to lackof awareness.

108. A phenomenal change in private sector financing in Bangladesh can therefore beexpected as regulatory directives gradually increase the volume of rating activities. Assessmentof capital adequacy of banks through the credit ratings of borrowers has heightened the generalinterest in the credit rating industry.

109. The government has been working on developing debt markets by issuing benchmarktreasury bonds with maturities of 5, 10, 15, and 25 years. Besides, the Government ofBangladesh seeks capital markets as an avenue for financing large infrastructure projects andoffloading public sector entities. Therefore, the outlook for expanding local debt market and

credit rating activities is promising.


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APPENDIX 1: ADB BEST PRACTICE HANDBOOK

Requirement of international best practice suggested by ADB handbook

I. ESSENTIAL BEST PRACTICES

1 Pre-Rating Requirements

1.1 Written contract between DCRA and ratee

1.2 DCRA cannot promise, assure, or guarantee a particular rating outcome1.3 Rating definitions, policy for use, and rating criteria are to be explained to the rating entity before rating

services are engaged

1.4 Publication of policies and processes

1.5 Availability of adequate resources personnel with skills facilities such as software for informationprocessing and regular training, and adequate financial resources for business development, outreachactivities, and surveillance process with minimum capital suggested $3 million$5 million

1.6 Revision in organizational structure and rating process

2 Rating Definitions and Recognition of Default

2.1 Disclosure whether rating indicates probability of default or expected loss

2.2 Preparation of concrete definition of default

3 Policies and Processes for Rating

3.1 Consistency in application of rating policies

3.2 Use of updated criteria and management meetings for ratings assignments3.3 Initial rating assignment and appeal process

3.4 Publication of ratings

3.5 Surveillance policy

3.6 Withdrawal policy

3.7 Formation of functional groups

3.8 Training plan

3.9 Preparation of operations manual

3.10 Policies for dependence on third party

3.11 Miscellaneous other activities

4 Confidentiality Requirements

4.1 Confidentiality of ratees information

4.2 Applicability of confidentiality to all employees4.3 No access to those not involved in the rating assignment

4.4 Contractual arrangement to ensure confidentiality

5 Analytical Independence and Avoidance of Conflicts of Interest

5.1 Policies to manage conflicts of interest

5.2 Policies on trading and investment declaration

5.3 Formulation of other policies to ensure independence and avoidance of conflicts of interest

6 Private, Unaccepted, and Unsolicited Ratings

6.1 Formulation and adherence to policies

7 General Code of Conduct

7.1 Adoption of internal code

7.2 Affirmation of compliance with code

8 The International Organization of Securities Commissions (IOSCO) Code of Conduct

8.1 Adherence to the code of conduct9 Process Audit and Compliance Officer

9.1 Institution of audit process

9.2 Appointment of Compliance Officer

9.3 Whistle-blower policy

continued next page


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Continued from previous page

10 Outreach Initiatives

10.1 Initiation of outreach activities

11 Relation with Regulator and Other Domestic Rating Agencies (DCRAs)

11.1 Formulation of relevant policies and compliance

4.1 Computation of Default Statistics

4.1.1 Every rating agency should publish, at least annually, a default and transition study, along with themethodology used for calculating default rates.

4.1.2 In the methodology employed for calculation of the default rates, the common features designated inthe handbook are recommended.

4.1.3 Transition rates should ideally be calculated and published on the basis of a 1-year observed transition.

4.2 Dedicated Advanced Functional Groups

Have the following functional groups been formed:(a). Industry focus group

(b). Quality assurance group

(c). Library and data management group

4.3 Conflicts of Interest between Other Businesses:Has detailed due diligence been undertaken in areas where co-mingling of diverse DCRA businesslines pose conflicts of interest, and in such cases have operational firewalls been put in place andare they fully adhered to?

4.4 Are Rating Enhancers Used as Early Warning Indicators?

4.5 Are the Rating Criteria Published?

4.6 Is Market Feedback Obtained before Major Policy Changes?


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APPENDIX 2: CREDIT RATING SYSTEM DEVELOPMENTFOR SMALL AND MEDIUM-SIZED ENTERPRISES

A. Background

1. Small and medium-sized enterprises (SMEs) are a priority policy area for the

Bangladesh government, holding the key to inclusive socioeconomic growth in the country.SMEs are usually born out of entrepreneurial passion, which is generally backed by limitedfunding. Business systems are often heterogeneous and independent. Moreover, tangible andintangible business assets of SMEs are rudimentarily defined, and the value of such assets isoften only partially known. Typically this is the case with one of the most important assets,namely, information.

2. SMEs face a plethora of challenges in terms of lack of access to information, lack ofadequate finance, technological disadvantages, and backdated marketing and managerial skills.

3. Bangladesh Bank has reported that SME lending grew 17.02% in AprilJune 2012 overAprilJune 2011 while having achieved only 24.20% of the sector target, indicating the immense

potential that is locked in this space.

4. The segment is still immature and does not display standard patterns. The success ofthe SME development strategy outlined by Bangladesh Bank also depends on an individualbanks strategic interest in the SME business, which includes many factors:

(i) demand for credit;(ii) competition among the banks in different segments;(iii) corporate strategy of banks, i.e., are they corporate-focused or SME-focused?;(iv) macroeconomic, regulatory, and institutional factors; and(v) business model and risk management processes used by the bank when dealing with

SMEs, which answers the following questions: How is financing promoted? How is cost minimized? How is credit risk managed and how are risks controlled?

B. Inadequate FundingA Key Constraint to Growth of Small andMedium-sized Enterprises

5. Access to finance has been extensively studied in Bangladesh, identified as a majorbarrier to growth of small enterprises. Whenever the credit is available, the rate of interest ishigh and at par with that for large enterprises. These barriers are of many kinds and in loweringthem lies the key to unlocking SME growth.

6. Lack of access to finance. Institutional limitations, such as an underdeveloped andinefficient legal and regulatory framework, pose significant barriers to effective financing. Banksface a number of issues in lending to SMEs, the most pronounced being information asymmetryand granularitythe level of detail available on which to base business decisions. Banks do nothave the requisite information and systems in place to quantify risk and differentiate betweenSMEs. This has resulted in tightened credit terms and inefficient allocation of resources.

Another factor is the issue of moral hazard, wherein SMEs are perceived to take higher risksthan larger companies with funds borrowed from banks. Therefore, a mechanism should be


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banks such as BRAC Bank, Standard Chartered Bank, Islami Bank, and Eastern Bank, whichfollow their own credit risk models customized to SMEs) use the same risk managementframework as that for corporate firms and large enterprises to arrive at a lending decision.Under the Basel II framework, for calculating capital adequacy of banks, the SME segment doesnot necessarily require external credit rating. Therefore, banks in general follow the CRGsystem of Bangladesh Bank to assess SMEs.

12. The CRG system of Bangladesh Bank is limited by the fact that it does not differentiatebetween SME risk and corporate risk. The risk grading matrix provided in the manual only sets abaseline, minimum standard for internal risk rating.

13. Bangladesh Bank actually gave a broader risk management framework within which acommercial bank, depending on its strategy and risk appetite, could use to adopt an appropriaterisk management metric that could be customized to a mix of borrowers across SME, corporate,and retail segments.

14. However, because of high risk and high transaction cost perceived in lending to SMEsand in the absence of appropriate credit risk management and monitoring tools, most banks are

reluctant to take a large stake in SME lending.

15. Therefore, irrespective of whether the potential borrower is an SME or a corporate firm,banks rely more on collateral, which is a serious obstacle for SMEs.

16. Cumbersome documentation process. Borrowers face difficulties in comprehendingdocumentation processes stipulated by lenders, many of which have been found to benumerous and complex.

17. Limited spread and reach of banks.The limited network of banks in smaller towns andrural areas restricts borrowers access to credit. Although the banking sector is the mostimportant source of external financing for SMEs, they underserve the needs of the sector. Many

SMEs are forced to rely on retained earnings and informal avenues for borrowing that can takeconsiderable time to accumulate. Shortage of finance could well be the primary impairment tothe competitiveness and growth of SMEs in Bangladesh.

C. How Recognized Domestic Credit Rating Agencies Can Contribute toCredit Rating and Development of Small and Medium-sized Enterprises

18. Modern credit risk appraisal through DCRAs recognized by Bangladesh Bank bringssignificant advantages for SMEs.

19. Appropriate evaluation and risk assessment through a credit rating approach customizedto SMEs as opposed to a conventional approach can make it easier for them to borrow.

Creating a rating system for SMEs is not easy as it is not merely about tweaking a processmeant for assessing large companies. Producing a new framework for rating SMEs is important,because most enterprises would otherwise receive low ratings on traditional scales solelybecause of their small size. The benchmarks used for large corporations have to be abandoned.One of the common misconceptions about SMEs is that they are unwilling to incur the cost ofbeing rated. As more SMEs that decide to be rated find that this eases their access to bankloans and reduced interest rates, the proclivity in the segment to undergo the credit ratingprocess will also rise.


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20. Bank lending to SMEs can expand only if the existing credit risk management frameworkis augmented and appropriate tools and techniques are devised and applied to assessingriskiness of SMEs.

21. This paper proposes a rating scale of SME1 to SME8 that can be used to rate SMEsusing the data of other SMEs as peer and benchmark such that there is a better spread across

sectors and profiles of different units can be compared.

22. The proposed SME rating scale is presented in Table A2.1.

Table A2.1: Proposed Rating Scale for Assessing Credit-Quality Ratings Assignedby a Domestic Credit Rating Agency to a Small or Medium-sized Enterprise

SME = small and medium-sized enterprise.

23. Table A2.2 presents an SME scoring system and a framework comprising key analyticaldeterminants of rating, sub-factors, and their weights.

24. It is noted that ratings are forward looking and incorporate expectations of future

financial and operational performance. The rating process makes use of both historical andprojected financial results. Historical results of operations help the analyst understandperformance patterns and draw peer comparisons. Historical data helps the analyst to lookthrough the earnings volatility associated with the business cycle and evaluate whetherprojected future results are realistic. The rating process makes use of both historical andprojected financial results. It is also possible that in specific SMEs any one parameter mayoverride other parameters to such a large extent that it may become a rating driver.

D. Mapping Rating Factors to Rating Categories

25. On the rating scale of SME1 to SME8, value ranges (in minimummaximum pairs) foreach sub-factor may be set based on the DCRAs expectations for each rating category. With

the ranges identified, the DCRA may map the outcomes for each sub-factor to a rating category:

(i) For quantitative sub-factors, such as those related to earnings or profitability, theDCRA could place a firms actual EBITDA margin against the SME1 to SME8 scale forEBIDTA to see where it fits.

(ii) For the qualitative sub-factors, the DCRA could assign sub-factor rankings either for all the firms relative to one another or based on absolute criteria including both quantitative and qualitative parameters. As with quantitative sub-factors, DCRA could use the SME1 to SME8 scale.

Rating Notches Rating Definition

SME 1 Highest quality

SME 2 High quality

SME 3 Adequate

SME 4 ModerateSME 5 Inadequate

SME 6 Risk-prone

SME 7 Poor

SME 8 Poorest


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Table A2.2: Rating Factors and Sub-Factors and Their Weights

Rating Factors Weight (%)

1. Operational and Business Risk 40.00

Premises, Product and Services, People Element, Purchasing, Protection,Procedures, Performance, Planning, Policy, and Processes

2. Environmental Risk 5.003. Financial Risk 35.00

Earnings and Stability 5.25

Sales

EBITDA Trends

Profitability 5.25

EBITDA Margin

ROA

Liquidity 3.50

Liquidity Index

Current/Quick Ratio

Working Capital Management 7.00

OI/NWC

Sales to Working Capital LimitAverage Inventory Period

Average Collection Period

Average Payment Period

Leverage and Net Worth 7.00

Debt/EBITDA

D/(D+E)

Coverage 7.00

EBIT/Interest

DSCR

4. Management Risk 20.00

Promoters Track Record and Qualification 8.00

Management Quality and Succession Planning 6.00

Administrative Setup and Delegation Culture 6.00DSCR = debt service coverage ratio; EBITDA = earnings before interest, tax, depreciation and amortization; OI/NWC = operatingincome/net working capital; ROA = return on asset.Notes:

i. Each rating factor (Factor 1 to Factor 4) is given a weight based on the importance of that particular factor in the rating.The sum of factors weighted should equal to 100. The weights assigned to various parameters may vary from SME to SMEdepending on the specifications of the said enterprise.

ii. Based on the risk analysis, each sub-parameter is assigned an appropriate rating score.iii. The weighted rating score for each rating sub-parameter is then computed by multiplying its weight with its rating score.iv. The total weighted rating score is then arrived at by calculating the sum of the sub-parametric weighted rating scores and

rounding it off to the nearest integer.v. Using the DCRAs Look-up Table, the rating equivalent to the total weighted rating score is arrived at.vi. This rating can be deemed to be the model implied rating.vii. Model implied rating may be adjusted with sector-specific issues and deemed to be the final rating.

26. Once the broad rating category has been determined for each sub-factor, it could beconverted into a numerical equivalent, as per the conversion table presented in Table A2.3:

Table A2.3: Conversion of Factor Ratings into Numeric Values

Rating Categories SME1

Documents

Regulatory Framework and Role of Domestic Credit Rating Agencies in Bangladesh