Role of credit rating in the banking sector after introduction of basel ii regulation

ROLE OF CREDIT RATING IN THE BANKING SECTOR AFTER INTRODUCTION OF BASEL II REGULATION- A

REVIEW ON BANGLADESH CONTEXT;

By

Md. Shahinuzzaman Registration No: 01879, Session: 2008-2009

Department of Finance and Banking Faculty of Business Administration and Management

PATUAKHALI SCIENCE AND TECHNOLOGY UNIVERSITY DUMKI, PATUAKHALI- 8602.

April, 2013

INTERNSHIP REPORT

Dedicated to……

My Parents

ROLE OF CREDIT RATING IN THE BANKING SECTOR AFTER INTRODUCTION OF BASEL II REGULATION- A REVIEW ON

BANGLADESH CONTEXT;

April, 2013

Patuakhali Science and Technology University

Dumki, Patuakhali-8602

ROLE OF CREDIT RATING IN THE BANKING SECTOR AFTER

INTRODUCTION OF BASEL II REGULATION- A REVIEW ON BANGLADESH CONTEXT

By

Md. Shahinuzzaman

Registration Number: 01879

ID: 0803017

An Internship Report Prepared for the Partial Fulfillment

of the Requirements for the Degree

Bachelor of Business Administration


April, 2013

An Internship Report

On

“Role of Credit Rating in the Banking Sector after Introduction of Basel II

Regulation- A Review on Bangladesh Context”

By

Md. Shahinuzzaman Examination Roll Number: 0803017

Registration Number: 01879 Session: 2008-2009

Bachelor of Business Administration (BBA) Major in Finance and Banking

Submitted to the Department of Finance and Banking Faculty of Business Administration and Management

In Partial Fulfillment of the Requirements for the Degree Bachelor of Business Administration

PATUAKHALI SCIENCE AND TECHNOLOGY UNIVERSITY

DUMKI, PATUAKHALI-8602.

April, 2013

Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation- A Review on Bangladesh Context;

An Internship Report

Has been approved on April, 2013


……….………………………………………… Md. Nur Nabi

Assistant Professor Internship Supervisor



…………………………………………………… Omar Faruque

External Examiner Assistant Professor

Department of Finance Jagannath University, Dhaka

………………………………………………….. M. Takibur Rahman

Internship Co-supervisor Assistant Professor



1st April, 2013 To Md. Nur Nabi Assistant Professor and Internship Supervisor Department of Finance and Banking Faculty of Business Administration and Management Patuakhali Science and Technology University, Dumki, Patuakhali-8602.

Subject: Letter of Transmittal

Dear Sir It is a great pleasure for me to submit here with my dissertation, which has been prepared under the sound and dynamic leadership of a personality like you. This internship report is an integral part of my academic program in completion of the degree named Bachelor of Business Administration, which has assigned me “Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation- A Review on Bangladesh Context” as a part of B.B.A. Program. I have tried my best to collect the relative information as comprehensive as possible in preparing the report. During preparation of the report I have experienced practically a lot that will help me a great in my career. It has enlightened my practical knowledge regarding the present credit rating system. I will be able to explain anything for more clarification if necessary. I would like to thank you, for giving me the opportunity to do a report on the above mentioned topic. With best regards ………………………………… Md. Shahinuzzaman Examination Roll Number: 0803017 Registration Number: 01879 Session: 2008-2009 Major in Finance and Banking Bachelor of Business Administration (BBA) Faculty of Business Administration and Management Patuakhali Science and Technology University Dumki, Patuakhali-8602

1st April, 2013 To Md. Nur Nabi Assistant Professor and Internship Supervisor Department of Finance and Banking Faculty of Business Administration and Management Patuakhali Science and Technology University, Dumki, Patuakhali-8602.

Subject: Letter of Authorization

Dear Sir This is our truthful declaration that the Report on “Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation- A Review on Bangladesh Context” is not an exact copy of any research report or book previously made by others. I also express my honest confirmation in support of the fact that the report has neither been used before to fulfill any other course related purposes and not it will be submitted to any other person or authority in future.

With best regards ………………………………… Md. Shahinuzzaman Examination Roll Number: 0803017 Registration Number: 01879 Session: 2008-2009 Major in Finance and Banking Bachelor of Business Administration (BBA) Faculty of Business Administration and Management Patuakhali Science and Technology University Dumki, Patuakhali-8602

Faculty of Business Administration and Management Patuakhali Science and Technology University Dumki, Patuakhali-8602 Tel: 04427-56014, 01813899621Fax: 04427-56009, E-mail: [email protected]

ENDORSEMENT OF THE SUPERVISOR It is our pleasure to certify that, Md. Shahinuzzaman, student of Bachelor of Business Administration (BBA), Patuakhali Science and Technology University, Dumki, Patuakhali-8602; has been completed the Internship Program at “Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation- A Review on Bangladesh Context” under my supervision from 1st January , 2013 to 31st March, 2013. I wish him success in his life. ………………………………………. Md. Nur Nabi Assistant Professor and Internship Supervisor Department of Finance and Banking Faculty of Business Administration and Management Patuakhali Science and Technology University, Dumki, Patuakhali-8602.

“Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation” – A Review on Bangladesh Context; I

Foreword……

“…In the name of Allah who can do everything without anything…”

It is with pleasure and affection that I acknowledge my indebtedness to my honorable Course teacher Md. Nur Nabi, Assistant Professor, Department of Finance and Banking, Faculty of Business Administration and Management, Patuakhali Science and Technology University, Dumki, Patuakhali, who has assigned me to prepare this report and help me with his support, encouragements and expertise. As an intern student of BBA, I am lucky incredibly to have such a report which is a very rare initiative of working on “Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation”- a Review on Bangladesh Context; So I am very grateful to my honorable course teacher because of his trust on me for preparing such a report in which I haven’t had enough strong familiarity on this ground.

My total efforts represent broad and throughout discussion of the role of credit rating in the Banking Sector after introduction of Basel II Regulation in Bangladesh. The purpose of this report is to fulfill the internship requirement for the Bachelor of Business Administration in Patuakhali Science and Technology University, Dumki, Patuakhali-8602. While, I was employed as an intern at WASO Credit Rating (BD) Ltd.: Haque Chamber (Level-5 & 6), 89/2, West Panthapath, Dhaka-1215, Bangladesh.

This report summarizes the role of credit rating in the banking sector in Bangladesh. Though I face many problems I have tried my best to go into deep and present a report.

…………………………. Md. Shahinuzzaman Reg. No.: 01879 Session: 2008-2009 Major in Finance and Banking Faculty of Business Administration and Management Patuakhali Science and Technology University, Dumki, Patuakhali-8602.

“Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation” – A Review on Bangladesh Context; II

Acronyms (Alphabetic order)

ACRCL=ARGUS Credit Rating Company Limited BAM=Business Administration and Management BB=Bangladesh Bank BCBS= Basel Committee on Banking Supervision BDRAL=Bangladesh Rating Agency Limited BoD=Board of Director CAR=Capital Adequacy Ratio CEO=Chief Executive Officer CR=Credit Rating CRA=Credit Rating Agency CRISL= Credit Rating Information and Services Limited CRAB=Credit Rating Agency of Bangladesh CRD=Capital Requirements Directive DSE=Dhaka Stock Exchange EBIT=Earnings before Interest and Taxes ECAI’s=External Credit Assessment Institution ECRL=Emerging Credit Rating Limited EU= European Union FASB=Financial Accounting Standard Board FD=Fair Disclosure GDP=Gross Domestic Product IASB=International Accounting Standard Board ICAAP=Internal capital Adequacy Assessment Process ICCMS= International Conference on Computational Management Science ICRA= Internet Content Rating Association IFS=Issuer Financial Strength IMF=International Monetary Fund IOSCO= International Organization of Securities Commissions IRB=Internal Rating-Based IT=Information Technology LC=Letter of Credit LOSCO= Louisiana Oil Spill Coordinator's Office MCR=Minimum Capital Requirements NBFI=Non-Banking Financial Institutions NCRL=National Credit Rating Limited PSTU=Patuakhali Science and Technology University RoA=Return on Asset RoE=Return on Equity SEC=Securities and Exchange Commission SLR/CRR= Statutory liquidity ratio/Cash Reserve Ratio SME=Small and Medium Enterprise SRO= Statutory Regulatory Order SRP=Supervisory Review Process UK=United Kingdom WB=World Bank WCRCL=WASO Credit Rating Company Limited WTO=World Trade Organization

“Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation” – A Review on Bangladesh Context; III

Verse of Gratitude……

I would like to acknowledge the following people for their support and assistance with this internship, especially the person I most wish to thank is my academic internship supervisor Md. Nur Nabi, Assistant Professor, Department of Finance and Banking, PSTU. My cordial thanks also to my Co-Supervisor M. Takibur Rahman, Assistant Professor, Department of Accounting and Information Systems, PSTU and Omar Faruque, Assistant Professor, Department of Finance, Jagannath University, Dhaka.

I am very much grateful to the authority of WASO Credit Rating Limited to assign me as an internee and have the opportunity to learn theoretical as well as practical knowledge related to credit rating system and complete such an ambitious study for my internship program as well as for preparation of this report.

Next I would like to show my heartiest gratitude towards Juthi Akter, Financial Analyst, WCRCL. She hse truly been extremely supportive to me in spite of her busy schedule. It wouldn’t possible to thank all of those marvelous people of WASO Credit Rating Limited. They have explained everything I asked for in details. Throughout time they were never impatience. They did not allow me to feel uncomfortable for even a single moment. I am really grateful to all for their supportive and friendly behavior.

All the people have been kind enough to take the time off their busy schedule and help me in collecting the necessary information.

“Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation” – A Review on Bangladesh Context; IV

Table of Contents . . . . . . SL No.

Particulars Page No.

Foreword I Acronyms II Word of Gratitude III Table of Contents IV-V

List of Tables VI List of Graphs VI List of Appendixes VI

Chapter-01(Introduction)

Abstract 1 Keywords 1

1.1 Introduction 2 1.2 Definition of the Study 2 1.3 Origin of the Study 3 1.4 Purpose of the Study 3 1.5 Rationale of the Study 3 1.6 Objectives of the Study 4 1.7 Scope of the Study 4 1.8 Methodology 4

1.8.1 Sources of Data 4 1.8.2 No. of Companies 4 1.8.3 Data collection methods 5 1.8.4 Data processing 5

1.9 Limitations of the study 5 1.10 Literature Review 5-6

Chapter-02(Credit Rating and Basel II)

2.1 Overview of Credit Rating 7 2.1.1 Meaning and Definition of Credit Rating 7

2.1.2 Origin of Credit Rating (CR) and Credit Rating Agencies (CRA’s) 7 2.1.3 Credit Rating and Bangladesh 8-9 2.1.4 Overview of Credit Rating Agencies in Bangladesh 9-11 2.1.5 Functions of a Credit Rating Agency 11 2.1.6 Advantages and Disadvantages of Credit Ratings 12-14

2.2 Overview of Basel II 14 2.2.1 Meaning and Definition of Basel II 14

2.2.2 Background of Basel II 14-15 2.2.3 The main objective of the Basel II Accord is to: 15 2.2.4 The Basel II Framework consists of three pillars: 15-17 2.2.5 The significant features of Basel II 18 2.2.6 Basel II Implementation Scenario in Bangladesh 18

“Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation” – A Review on Bangladesh Context; V

2.2.7 Positive and Negative Impact of Basel II 19-20 2.2.8 Role of Rating Agencies under Basel II 21

2.2.9 Problems in Developing Countries: 21 2.3 Matrix of Participants in the Basel Process 21-22

Chapter-03 (Credit Rating System and Mapping)

3.1 Credit Rating Systems or Modus Operandi of WCRCL 23 3.2 Mapping comparison 24

Chapter-04 (Credit Rating Methodology)

4. Rating Methodology 25 4.1 List of Rating Methodologies in BD ECAI’s 26-27 4.2 Corporate Rating Methodology 28-33 4.2.1 Diagram of Corporate Rating Methodology 34 4.2.2 Comparison among the Methodologies of Different ECAI’s 35-36

4.3 Banks and Non-Banking Financial Institution Rating Methodology 37-40 4.3.1 Diagram of Banks and NBFI’s Rating Methodology 40 4.3.2 Comparison among the Methodologies of Different ECAI’s 41

4.4 Small Medium Enterprises (SMEs) Rating Methodology 42-43 4.4.2 Comparison among the Methodologies of Different ECAI’s 44

4.5 General Insurance Rating Methodologies 45-48 4.5.1 Diagram of GI’s Rating Methodology 48 4.5.2 Comparison among the Methodologies of Different ECAI’s 49-50

4.6 WCRCL Rating Scales & Definitions 51-52

Chapter-05 (Growth and Impact of Rating after Basel II)

5.1 Total Credit Rating Scenario in Bangladesh from 2008-2012 53 5.2 The Growth Rate of credit rating in 2009-2012 53 5.3 Total number of Rating in 2012 by Credit Rating Agencies 54 5.4 Rating by CRISL & CRAB in 2008-2012 54 5.5 Total number of Rating in 2012 by Credit Rating Agencies (Grading Wise) 55

Chapter 06(Bank Performance (pre and post of Basel II)

6.1 Bank Performance (pre and post of Basel II) 56-57 6.2 Importance of Credit Rating in the Banking Sector 58 6.3 Impact of Basel II on banking industry 58-59

Chapter-07 (Conclusion)

7.1 Prospects 60 7.2 Findings of the Study 60-61 7.3 Recommendations 61-62 7.4 Conclusion 62-63 7.5 References 63-64 7.6 Appendices 65-68

“Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation” – A Review on Bangladesh Context; VI

List of Tables: No: Name Page Table-1 : The list of Credit Rating Agencies in Bangladesh 9 Table-2 : Evolution of the Regulatory Environment 14 Table-3 : Matrix of Participants in the Basel Process 21 Table 4 : Mapping Comparison 24 Table-5 : Sequential steps in the total rating assessment process 34 Table-6 : Comparison among the Corporate Rating Methodology of Different ECAI’s 35-36 Table-7 : Comparison among the Banks and FI’s Methodology of Different ECAI’s 41 Table-8 : Comparison among the SME’s Methodology of Different ECAI’s 44 Table-9 : Comparison among the General Insurance Methodology of Different ECAI’s 49-50 Table-10 : WCRCL Rating Scales & Definitions 51-52 Table-11 : Aggregate profitability ob banking Industry in Bangladesh 56

List of Figures: No: : Name Page Figure-1 : Summary of Basel II 15 Figure-2 : Credit Rating Systems 23 Figure-3 : Rating Methodology 25 Figure-4 : Corporate Rating Methodology 34 Figure-5 : Banks and Financial Institution Rating Methodology 40 Figure-6 : General Insurance Rating Methodology 48 List of Charts or Graphs:

No: Name Page Graph-1 : Total Credit Rating Scenario in Bangladesh from 2008-2012 53 Graph-2 : Growth Rate of credit rating in 2009-2012 53 Graph-3 : Rating in 2012 by Credit Rating Agencies 54 Graph-4 : Rating by CRISL & CRAB in 2008-2012 54 Graph-5 : Rating in 2012 by Credit Rating Agencies (Grading Wise) 55 Graph-6 : Aggregate Return on Asset of Banking Industry in Bangladesh 56 Graph-7 : Aggregate Return on Equity of Banking Industry in Bangladesh 57 Graph-8 : Aggregate Return on NIM of Banking Industry in Bangladesh 57

List of Appendixes: No: Name Page Appendix-1 : Rating Methodology Published BB 65 Appendix-2 : Rating Map Published BB 66 Appendix-3 : Rating in 2012 by Credit Rating Agencies 67 Appendix-4 : Rating Matrix in 2012 67 Appendix-5 Aggregate profitability ob banking Industry in Bangladesh 68

“Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation” – A Review on Bangladesh Context; A

Chapter # 01 INTRODUCTION

Abstract 1.1 Introduction 1.2 Definition of the Study 1.3 Origin of the Study 1.4 Purpose of the Study 1.5 Rational of the report 1.6 Objectives of the Study 1.7 Scope of the Study 1.8 Methodology 1.9 Limitations of the Study 1.10 Literature Review

“Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation” – A Review on Bangladesh Context; 1

“Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation”- A Review on Bangladesh Context;

Md. Shahinuzzaman (April, 2013) [email protected]

Keywords: Credit Rating (CR), Credit Rating Agency (CRA), Basel II, WASO credit Rating Co. (BD) Ltd., Credit Risk, Standard Approach.

1.1 Introduction:

Credit Rating Agencies (subsequently denoted CRAs) specialize in analyzing and evaluating the creditworthiness of corporate and sovereign issuers of debt securities. In the new financial architecture, CRAs are expected to become more important in the management of both corporate and sovereign credit risk. Their role has recently received a boost from the revision by the Basel Committee on Banking Supervision (BCBS) of capital standards for banks culminating in Basel II. The logic underlying the existence of CRAs is to solve the problem of the informative asymmetry between lenders and borrowers regarding the creditworthiness of the latter. Issuers with lower credit ratings pay higher interest rates

Abstract: Credit Rating Agencies (CRAs) play a key role in financial markets by helping to reduce the informative asymmetry between lenders and investors, on one side, and issuers on the other side, about the creditworthiness of companies or countries. CRAs' role has expanded with financial globalization and has received an additional boost from Basel II which incorporates the ratings of CRAs into the rules for setting weights for credit risk. Ratings tend to be sticky, lagging markets, and overreact when they do change. This overreaction may have aggravated financial crises in the recent past, contributing to financial instability and cross-country contagion.

The recent bankruptcies of Enron, WorldCom, and Parmalat have prompted legislative scrutiny of the agencies. Criticism has been especially directed towards the high degree of concentration of the industry. Promotion of competition may require policy action at national and international level to encourage the establishment of new agencies and to channel business generated by new regulatory requirements in their direction.

Financial regulators recognize certain credit rating agencies for regulatory purposes. However, it is often argued that credit rating agencies have an incentive to assign inflated ratings. This paper studies the Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation- A Review on Bangladesh. Credit rating agencies may collude to assign inflated ratings. Yet it is showing that there exists vast role which induces credit rating agencies to assign correct ratings.


embodying larger risk premiums than higher rated issuers. Moreover, ratings determine the eligibility of debt and other financial instruments for the portfolios of certain institutional investors due to national regulations that restrict investment in speculative-grade bonds.

The importance of credit rating is to protect the investor who cannot get inside information about the instruments for investment due lack of time and lack of expertise. credit rating has assumed an important place in the modern and developed financial markets. It is a boon to the companies as well as investors. It facilities the company in raising funds in the capital market and helps the investors to select their risk return trade off. As investors are concerned with the timely payment of interest and principal, credit rating indicates the credit worthiness of borrowers. Credit rating essentially indicates the risk involved in a debt instruments as well as its quality. Higher the credit rating greater is the probability that the borrower will make timely payment of principal and interest and vice versa.

Thus credit rating is not a general evaluation off the issuing organization. it essentially reflex the probability of timely repayment of principal and interest buy a borrower a company . The credit rating is not a onetime evaluation of credit risk of a security. The rating agency may change the rating considering the changes periodically. Despite their ubiquity in the financial markets, credit ratings are often misunderstood. Confusion about what credit ratings are, and the role they play in the financial system, has sometimes led to their misuse and prevented them from fulfilling their true role: that is, to help close the information gap between lenders and borrowers by providing independent opinions of creditworthiness.

The credit rating has created an environment for a mushroom growth of such agencies in Bangladesh as many industry or people have started considering it as a solid business proposition without going into greater details. However, rating is a research on fundamentals. The fate of the rating agencies is absolutely uncertain and the current scenario is bound to destroy the rating market and ultimately most of the rating agencies are bound to face closure, with the moving of the banks towards Internal Rating Based (IRB)-approach as per road map of Bangladesh Bank.

In this paper, there have seven chapters. 1st chapters include introduction, objectives, methodology and etc. 2nd chapter about credit rating and Basel II, 3rd chapter about credit rating system and mapping, 4th chapter about credit rating methodology, 5th chapter include growth and impact of rating after Basel II, 6th chapter include pre and post scenario of banking industry after Basel II introduction and finally chapter 7th include prospect, findings, recommendation, conclusion and references.

1.2 Definition of Study:

Study is a presentation of acts best on intensive review, observation, data analysis and interpretation etc. It highlights the role of credit rating in the Banking Sector after introduction of Basel II Regulation in Bangladesh.


1.3 Origin of the Study: Practical acquaintance is fundamental part for applying academic intelligence. Bearing this motto in mind the internship program was being included in Bachelor of Business Administration program. After completing one hundred and twenty six credit hours at Patuakhali Science and Technology University (P.S.T.U.) under the Bachelor of Business Administration program, the student (I) was placed at WASO Credit Rating Co. (BD) Ltd. as an intern for three months by the Faculty of Business Administration and Management (BAM). This report is the result of internship program and requirement of the mentioned company on the selected topic “Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation” – A Review on Bangladesh Context;

1.4 Purpose of the Study: Knowledge and learning become perfect when it is associated with theory and practice. Theoretical knowledge gets its perfection with practical application. The primary purpose of this study is to provide the intern with the practical experience by orienting engaging with an organization. As our educational system predominantly text based, inclusion practical orientation program , as an academic component is as exception to the norm as the parties educational institution and the organization substantially benefit from such a program, it seems a “win-win situation”. It establishes contracts and networking contracts. Contracts may help to get a job. That is, students can train and prepare themselves for the job market. In such state of affairs the present aiming at analyzing the experience of practical orientation related to an appraisal of WASO Credit Rating Co. Ltd. 1.5 Rationale of the report: As a student of a faculty of business studies, it is helpful to gain the practical knowledge about an organization and its overall activities. By doing this kind of activities, we can enrich our practical knowledge .With the application of acquired knowledge we will be able to develop ourselves and compete globally. So, I can say that the rationale of this is comprehensive. The concept of credit rating by the rating agencies to support capital adequacy of the banks came up in view of the need for implementation of Base-II capital adequacy framework by Bangladesh Bank. Under Basel-II framework, Bangladesh Bank adopted a standardized approach for credit risk under which the services of rating agencies were required under certain strict terms and conditions. Bank client rating is a very sensitive issue in view of the fact that most of the private sector companies, enjoying banking facilities, are not maintaining standard financials for appropriate evaluation. In addition, the businesses of the clients are directly affected by the economy, government policy and many other considerations, in addition to the factors dependent on the sponsors. Unless and until all the above factors are properly evaluated through sectoral studies, the ratings are bound to give wrong signals.

In this study I have tried my level best to show the role of credit rating regarding the banking sector. This study will be helpful to evaluate the role of credit rating after introduction of Basel II.


1.6 Objectives of the Study: The first objective of preparing this report is to fulfill the partial requirements of the B.B.A program. Generally every study is conducted to get one or more findings; if the findings are predetermined they called the objectives of the study. The main objective of this study is to evaluate the role of credit rating in the Banking Sector after introduction of Basel II Regulation in Bangladesh. To invent something new perfect investigation and by through above discussion of a known or unknown matter, and to make a right decision on that matter by achieving real knowledge about that mater, is the main objective of internship.

Some motives of internship are given below: 1. To make theoretical knowledge clear and exact about credit rating and Basel II. 2. Assessment of Credit Rating services by a banking sector before and after

implementation of Basel II. 3. Assessment of awareness for Credit Ratings in the corporate sector. 4. Finding the contribution of Credit Rating Companies in the Banking Sector

1.7 Scope of the Study: This report is a descriptive study which tries to focus on the theories and practices of Credit Rating Agencies in the context of Bangladesh. In connection with this effort, a study has been conducted on ECAI’s approved by the central bank in Bangladesh.

1.8 Methodology: 1.8.1 Sources of Data:

The study is related with both primary and secondary data. Primary data has been collected from practical work exposure and the direct interview of the senior employees of WASO Credit Rating Co. Ltd., Credit Rating Information and Services Ltd (CRISL), Credit Rating Agency of Bangladesh Ltd (CRAB), National Credit Ratings Ltd, Emerging Credit Rating Ltd and ARGUS Credit Rating Services Ltd. It should be noted that CRISL, CRAB, NCRL, ECRL and ARGUS are covering the momentous credit rating market in Bangladesh.

Secondary data has been collected form: Related information is collected through internet. Daily newspaper, journals. Web site of the concerned companies (www.crislbd.com, www.crab.com.bd,

www.ncrbd.com, www.emergingrating.com, www.acrslbd.com, www.wasocrditrating.com, www.apharating.com, www.bdral.com)

1.8.2 No. of Companies (CRAs): The data has been collected from the 8 credit rating companies operating their business in Bangladesh. The sample size is 8. Their listing are shown below-


01. Credit Rating Information and Services Ltd (CRISL) 02. Credit Rating Agency of Bangladesh Ltd (CRAB) 03 National Credit Ratings Ltd 04 Emerging Credit Rating Ltd 05. ARGUS Credit Rating Services Ltd. 06. WASO Credit Rating Company (BD) Limited 07. Alpha Credit Rating Limited 08. The Bangladesh Rating Agency Limited

1.8.3 Data collection methods: Considering the nature of the study- The study requires the published rating report of the respective companies. Data has been taken from the officials of the companies.

1.8.4 Data Analysis: All the related data in this study are already produced by the ECAI’s. Just I have made analysis to arrive at a decision.

1.9 Limitations of the Study:

The study is entitled to the following limitations- I have taken only three year period (2010- 2012) which is not enough to depict the

actual picture. Reluctance of the companies to disclose the rating report. All works have been done through computer so there is chance of printing mistake. As a growing and newly launched sector it’s not well established. It would be better if is it possible to highlights some additional banking scenario

(investment status, risk taking standard, etc.) pre and post of Basel II but for some constraints (lack of information, time, confidentiality, complex and slow process, etc.) it was not possible.

1.10 Literature Review: The role of credit rating has increased considerably during recent years. However, there is an unsettled debate about credit ratings’ impact and importance in the literature. On the positive side, Graham and Harvey (2001) show that credit ratings are more important in affecting a firm’s funding policy than factors suggested by capital structure theories. Along this front, Faulkender and Petersen (2006) reveal that firms which issue rated bonds are more leveraged. Kisgen (2006, 2009) finds that firms close to a rating upgrade or downgrade issue less debt than equity, relativeto firms without a rating change. Tang (2009) also documents that credit ratings significantly affect firms’ access to credit markets. Others, however, question the importance of credit ratings as providers of information. For example, Brealey and Myers (2003) argue that credit rating agencies reflect as much about market participants’ opinion about a firm’s financial condition as providing new information. The consequences of rating changes on the valuation of stock and bonds have been extensively examined. For example, Hand et al. (1992) show that only rating downgrades have a negative impact on stock and bond prices, while upgrades’ information is incorporated into prices prior to announcement. Ederington and Goh (1998) reveal that downgrades cause negative equity returns and


analysts’ earnings forecast revisions. Brooks et al. (2004) confirm that rating changes have the same impact on countries’ market returns as in the case of firms. Jorion et al. (2005) explore the effect of the Fair Disclosure (FD) Regulation in the US, which prohibited the selective, non-public disclosure of information by firms to favored investment analysts excluding credit rating agencies, to find that the informational effect on stock prices of downgrades and upgrades is much larger in the post-FD period.

In an effort to tie together the empirical findings, as well as to provide a comprehensive explanation for the increased role of credit ratings, Boot et al. (2006) develop a theoretical model to show that credit ratings coordinate investors’ beliefs. As they argue, credit ratings have a real value and impact through their monitoring role, especially in the credit watch procedure, and the significance of the ratings for institutional investors’ decisions. However, Boot et al. (2006) point out that market participants’ increased reliance on credit rating agencies might discourage other monitoring mechanisms and fuel an excessive dependence on them.

More recently, Kuang and Qin (2009) document the role and significance of credit ratings on firms’ managerial actions to find that credit ratings act as delegated monitors and deter managers’ risk taking incentives. In accordance with this finding, Kang and Liu (2009) provide evidence on the positive impact of rating changes on managers’ incentives. They show that credit ratings play a disciplinary role on managers’ actions and help reduce agency conflicts, in combination with other corporate governance mechanisms.

At present there are eight domestic credit rating agencies and no international or regional credit rating agencies exist in Bangladesh. The first, Credit Rating Information and Services Limited (CRISL), was set up in 1995 and got license from the Securities and Exchange Commission to operate as a rating agency in 2002. It is a joint venture of Malaysia Berhad, JCR-VIS Credit Rating Company of Pakistan, and a few financial institutions and professionals of Bangladesh. The second, the Credit Rating Agency of Bangladesh (CRAB), was established in 2003. CRAB received license in 2004 from SEC under ‘Credit Rating Companies Rules 1996’. CRAB formally launched its operation in April 2004. The sponsors are some leading personalities and professional in the private sector and institutions of the country. CRAB has technical collaboration with ICRA Limited of India, which is a subsidiary of Moody’s Investors Service. ICRA is one of the largest rating agencies in Asia. National Credit Ratings Ltd. and Emerging Credit Rating Ltd. were established in 22nd June 2010. Remaining four ARGUS Credit Rating Services Ltd., WASO Credit Rating Company (BD) Limited, Alpha Credit Rating Limited and The Bangladesh Rating Agency Limited were established in respectively 21st July 2011, 15th February 2012, 20th February 2012 and 7th March 2012.

Anytime that you apply for credit, whether it be for a credit card, auto loan or home loan, a lender will review your credit report and determine your credit rating. The higher you’re rating, the more likely you are to qualify, as well as to nab higher loan amounts and lower interest rates. A high credit rating can offer you a degree of financial freedom that those with a low rating may never see.

“Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation” – A Review on Bangladesh Context; B

Chapter # 02 OVERVIEW OF CREDIT RATING AND BASE II

2.1 Overview of Credit Rating 2.1.1 Meaning and Definition of Credit Rating 2.1.2 Origin of Credit Rating (CR) and Credit Rating Agencies (CRA’s) 2.1.3 Credit Rating and Bangladesh 2.1.4 Overview of Credit Rating Agencies in Bangladesh 2.1.5 Functions of a Credit Rating Agency 2.1.6 Advantages and Disadvantages of Credit Ratings 2.2 Overview of Basel II 2.2.1 Meaning and Definition of Basel II 2.2.2 Background of Basel II 2.2.3 The main objective of the Basel II Accord is to: 2.2.4 The Basel II Framework consists of three pillars: 2.2.5 The significant features of Basel II 2.2.6 Basel II Implementation Scenario in Bangladesh 2.2.7 Positive and Negative Impact of Basel II 2.2.8 Role of Rating Agencies under Basel II 2.2.9 Problems in Developing Countries: 2.3 Matrix of Participants in the Basel Process


2.1 Overview of Credit Rating 2.1.1 Meaning and Definition of Credit Rating

Credit rating is the opinion of the rating agency on the relative ability and willingness of tile issuer of a debt instrument to meet the debt service obligations as and when they arise. Rating is usually expressed in alphabetical or alphanumeric symbols. Symbols are simple and easily understood tool which help the investor to differentiate between debt instruments on the basis of their underlying credit quality. Rating companies also publish explanations for their symbols used as well as the rationale for the ratings assigned by them, to facilitate deeper understanding.

In other words, the rating is an opinion on the future ability and legal obligation of the issuer to make timely payments of principal and interest on a specific fixed income security. The rating measures the probability that the issuer will default on the security over its life, which depending on the instrument may be a matter of days to thirty years or more.

In fact, the credit rating is a symbolic indicator of the current opinion of the relative capability of the issuer to service its debt obligation in a timely fashion, with specific reference to the instrument being rated. It can also be defined as an expression, through use of symbols, of the opinion about credit quality of the issuer of security/instrument.

2.1.2Origin of Credit Rating (CR) and Credit Rating Agencies (CRA’s)

The credit rating system started in 1958 to keep track of which borrowers were not repaying on their deals. Over time, more lenders adopted the practice created by the Fair Isaac Corporation (FICO) to ensure better profits on their loans. As of 2009, the credit rating system serves over 80 countries across the globe.

The concept of using rating agencies to assess the level of risk associated with a debt arose around the beginning of the 20th century when three major credit rating agencies were formed. Although additional rating agencies were formed in subsequent years, the original rating agencies – Fitch, Moody’s, and Standard and Poor’s – are the most prominent.

1. Fitch

The Fitch Publishing Company was founded in 1913 by John Knowles Fitch, a 33-year-old entrepreneur who had just taken over his father’s printing business. Fitch had a unique goal for his company: to publish financial statistics on stocks and bonds.

In 1924, Fitch expanded the services of his business by creating a system for rating debt instruments based on the company’s ability to repay their obligations. Although Fitch’s rating system of grading debt instruments became the standard for other credit rating agencies, Fitch is now the smallest of the “big three” firms.


2. S&P

Henry Varnum Poor was a financial analyst with a similar vision to John Knowles Fitch. Like Fitch, Poor was interested in publishing financial statistics, which inspired him to create H.V. and H.W. Poor Company.

Luther Lee Blake was another financial analyst interested in becoming a financial publisher. In order to achieve this dream, Blake founded Standard Statistics in 1906, just a year after Poor’s death. Standard Statistics and H.V. and H.W. Poor published very similar information. Hence, it made sense for the two companies to consolidate their assets, and they merged in 1941 to form the Standard and Poor’s Corporation. Today, Standard and Poor’s not only provides ratings but also offers other financial services, such as investment research, to investors. They are now the largest of the “big three” rating agencies.

3. Moody’s

John Moody founded the financial holding company, Moody’s Corporation, in 1909. Although Moody’s provides a number of services, one of their largest divisions is Moody’s Investor Services. While Moody’s has conducted credit ratings since 1914, they only conducted ratings of government bonds until 1970.

Moody’s has grown significantly over the years. Presently, Moody’s is the second largest of the “big three” firms.

2.1.3Credit Rating and Bangladesh

The rating industry in Bangladesh is now considered to be a parentless industry. The behavior of the regulators towards nourishing this industry does not appear to be rational. As the researcher and initiator of this highly prestigious global profession, this scribe feels frustrated not because of the reason that there is a mushroom growth of licensing. The frustration is rather about the management of the regulatory framework. The authorities concerned have remained careless, while being responsible for creating such a bad environment. The rating agencies are still defined by the SEC rules as an investment advisory company. This has not changed over a long time. The paid-up capital still remains at Tk. 5.0 million (50 lakh), to start a rating agency by any group of sponsors. The regulators will realize the adverse consequences of such a situation at certain point of time when the total industry will lose its credibility in the national and international market.

Credit Rating Information and Services Limited, now popularly known as CRISL, carries the history of credit rating in Bangladesh. Although the Bangladesh capital market does not have enough work for one credit rating agency to survive on commercial consideration as a full-fledged rating agency, the regulators have licensed in total eight rating agencies till 2012.


At present, there are a number of rules and regulations that are directed towards credit rating. The Credit Rating Companies Rules 1996 (subsequently amended in 2009) of the Securities and Exchange Commission (SEC) is the mother regulation which provides for the credit rating of all debt instruments and right offers of equity securities at a premium. The direct listing rules of Dhaka Stock Exchange (DSE) provides for having, at least, BBB rating to be eligible for the purpose. The Bangladesh Bank (BB) made credit rating mandatory for all banks with annual surveillance in 2006. The insurance regulator of the country also through a SRO made the credit rating compulsory for all the general insurance companies and biannually for all life insurance companies.

2.1.4Overview of Credit Rating Agencies in Bangladesh

SL No.

Name of the Company Date of Issuance of Registration

Certificate

Address

01. Credit Rating Information and Services Ltd (CRISL)

21/08/02 Nakshi Homes (4th and 5th floor), 6/1A, Segunbagicha, Dhaka-1000

02. Credit Rating Agency of Bangladesh Ltd (CRAB)

24/02/04 Chamber Building (6th Floor), 122-124 Motijheel C/A, Dhaka-1000

03 National Credit Ratings Ltd

22/06/2010 3 BijoyNagor, 3rd floor, Dhaka-1000

04 Emerging Credit Rating Ltd

22/06/2010 SHAMS Rangs, House #104, Park Road, Flat# A1, A2, Baridhara, Dhaka-1212

05. ARGUS Credit Rating Services Ltd.

21/07/2011 13 level, BDBL Building, Motijheel, Dhaka.

06. WASO Credit Rating Company (BD) Limited

15/02/2012 Haque Chamber (Level-5), 89/2 West Panthopath, Dhaka-1205

07. Alpha Credit Rating Limited

20/02/2012 Navana Rahim Ardent (1st floor), 39 Kakrail, Dhaka-1000

08. The Bangladesh Rating Agency Limited

07/03/2012 47 Karwan Bazar, Latif Tower (12th floor), Dhaka-1215

Table 1: The list of Credit Rating Agencies in Bangladesh

CRISL

Credit Rating Information and Services Limited is a company that started its journey to implement a Concept in Bangladesh – “Credit Rating”. Before CRISL, “Credit Rating” was text paper words for the teachers and students of Bangladesh. The voyage of how CRISL conceptualized this idea in 1995 and implemented it in Bangladesh and finally achieved its operating license in 2002 – after almost eight years of struggle – has a long, interesting, exciting and also painful history. CRISL is now the national flagship company representing the profession at home and abroad.

CRAB

Credit Rating Agency of Bangladesh Ltd. (CRAB) was incorporated as a public limited company under the Registrar of Joint Stock Companies in August 2003 and received its


certificate for commencement of business in November 2003. It has been granted licence by the Securities & Exchange Commission (SEC) of Bangladesh for operating as a credit rating company in February 2004. The formal launching of the company was held on 5 April 2004.

NCRL

National Credit Ratings Limited (NCR) is a full service rating company that offers a wide range of services. Incorporated as a public company, NCR started its business with a paid up capital of TK 10.00 million. The Securities and Exchange Commission granted the license to NCR in June 2010 under the Credit Rating Companies Rules 1996.The Company is recognized by the Bangladesh Bank as an External Credit Assessment Institution (ECAI).

ECRL

The ISLQ International Star for Leadership in Quality Award acknowledges the strong commitment to quality and excellence. Mr. Ahsan Parvez (Managing Director& CEO) & Mr. Noor-e-Khoda Abdul Mobin (Deputy Managing Director& COO) received the award in the Concorde La Fayette Hotel in Paris on June 25, 2012, from the president of B.I.D., Mr. Jose E. Prieto. Emerging Credit Rating Ltd. is made up of a team oriented towards the continuous improvement of processes, striving for an important role in the leadership of the business world.

ACRSL

ARGUS Credit Rating Services Ltd. (ACRSL) is the next-generation Credit Rating Agency of Bangladesh. Founded as a joint-venture between global experts in credit & equity research and local sponsors with strong capital markets track record, ACRSL received its license from the SEC in 2011. ACRSL is partnered with DP Information Group (“DP”), the premier credit rating agency of Singapore for over 30 years. Having pioneered credit rating in Singapore, DP has played an influential role in the development of the credit rating sector in China, Indonesia, and Philippines. Further, DP’s parent company, the UK based Experian Group is one of the world’s top credit reference agencies.

WCRCL

WASO Credit Rating Company (BD) Ltd. (“WCRCL”) was incorporated as a public limited company under the Office of the Registrar of Joint Stock Companies and Firms in July of 2009. With the license from the Securities & Exchange Commission (SEC) of Bangladesh to operate as a credit rating company, WCRCL has officially started its journey on 15th February, 2012. It has also been recognized as an External Credit Assessment Institution (ECAI) by Central Bank of Bangladesh in October of 2012.


ALPHA

Alpha Rating was incorporated on the 24th of February 2011. a result of the initiative of a few distinguished and renowned professionals of Bangladesh and the with support and organizational assistance from SATCOM IT Ltd., Axis Resources Ltd., Equity Care Bangladesh Ltd., and TAN Equity and Investment Ltd.Date of Issuance of Registration Certificate is 20th February 2012.

BDRAL

The Bangladesh Rating Agency Ltd (BDRAL), a subsidiary of Dun & Bradstreet South Asia Middle East Ltd., is the pioneer in rating the SME sectors in Bangladesh.BDRAL has launched its SME ratings in Bangladesh following a successful pilot phase carried out in the year 2009.Date of Issuance of Registration Certificate is 7th March 2012.

2.1.5 Functions of a Credit Rating Agency A credit rating agency serves following functions:

1. Provides unbiased opinion:An independent credit rating agency is likely to provide an unbiased opinion as to relative capability of the company to service debt obligations because of the following reasons:

i. It has no vested interest in an issue unlike brokers, financial intermediaries. ii. Its own reputation is at stake.

2. Provides quality and dependable information:.A credit rating agency is in a position to provide quality information on credit risk which is more authenticated and reliable because:

i. It has highly trained and professional staff that has better ability to assess risk. ii. It has access to a lot of information which may not be publicly available.

3. Provides information at low cost: Most of the investors rely on the ratings assigned by the ratings agencies while taking investment decisions. These ratings are published in the form of reports and are available easily on the payment of negligible price. It is not possible for the investors to assess the creditworthiness of the companies on their own.

4. Provide easy to understand information: Rating agencies first of all gather information, and thenanalyze the same. At last these interpret and summarize complex information in a simple and readily understood formal manner. Thus in other words, information supplied by rating agencies can be easily understood by the investors. They need not go into details of the financial statements.

5. Provide basis for investment: An investment rated by a credit rating enjoys higher confidence from investors. Investors can make an estimate of the risk and return associated with a particular rated issue while investing money in them.

6. Healthy discipline on corporate borrowers: Higher credit rating to any credit investment enhances corporate image and builds up goodwill and hence it induces a healthy/ discipline on corporate.


7. Formation of public policy: Once the debt securities are rated professionally, it would be easier to formulate public policy guidelines as to the eligibility of securities to be included in different kinds of institutional port-folio.

2.1.6Advantages and Disadvantages of Credit Ratings 2.1.6.1 Advantages of Credit Rating The advantages, importance or benefits of credit rating to the investors are:-

1. Helps in Investment Decision: Credit rating gives an idea to the investors about the credibility of the issuer company, and the risk factor attached to a particular instrument. So the investors can decide whether to invest in such companies or not. Higher the rating, the more will be the willingness to invest in these instruments and vice-versa.

2. Benefits of Rating Reviews: The rating agency regularly reviews the rating given to a particular instrument. So, the present investors can decide whether to keep the instrument or to sell it. For e.g. if the instrument is downgraded, then the investor may decide to sell it and if the rating is maintained or upgraded, he may decide to keep the instrument until the next rating or maturity.

3. Assurance of Safety: High credit rating gives assurance to the investors about the safety of the instrument and minimum risk of bankruptcy. The companies which get a high rating for their instruments will try to maintain healthy financial discipline. This will protect them from bankruptcy. So the investors will be safe.

4. Easy Understandability of Investment Proposal: The rating agencies give rating symbols to the instrument, which can be easily understood by investors. This helps them to understand the investment proposal of an issuer company. For e.g. AAA (Triple A), given by CRISL for debentures ensures highest safety, whereas debentures rated D are in default or expect to default on maturity.

5. Choice of Instruments: Credit rating enables an investor to select a particular instrument from many alternatives available. This choice depends upon the safety or risk of the instrument.

6. Saves Investor's Time and Effort: Credit ratings enable an investor to his save time and effort in analyzing the financial strength of an issuer company. This is because the investor can depend on the rating done by professional rating agency, in order to take an investment decision. He need not waste his time and effort to collect and analyze the financial information about the credit standing of the issuer company.

The merits, advantages, benefits of credit rating to the issuing company are:- 1. Improves Corporate Image: Credit rating helps to improve the corporate image of a

company. High credit rating creates confidence and trust in the minds of the investors about the company. Therefore, the company enjoys a good corporate image in the market.

2. Lowers Cost of Borrowing: Companies that have high credit rating for their debt instruments will get funds at lower costs from the market. High rating will enable the company to offer low interest rates on fixed deposits, debentures and other debt securities. The investors will accept low interest rates because they prefer low risk instruments. A


company with high rating for its instruments can reduce the cost of public issue to raise funds, because it need not spend heavily on advertising for attracting investors.

3. Wider Audience for Borrowing: A company with high rating for its instruments can get a wider audience for borrowing. It can approach financial institutions, banks, investing companies. This is because the credit ratings are easily understood not only by the financial institutions and banks, but also by the general public.

4. Good for Non-Popular Companies: Credit rating is beneficial to the non-popular companies, such as closely-held companies. If the credit rating is good, the public will invest in these companies, even if they do not know these companies.

5. Act as a Marketing Tool: Credit rating not only helps to develop a good image of the company among the investors, but also among the customers, dealers, suppliers, etc. High credit rating can act as a marketing tool to develop confidence in the minds of customers, dealer, suppliers, etc.

6. Helps in Growth and Expansion: Credit rating enables a company to grow and expand. This is because better credit rating will enable a company to get finance easily for growth and expansion.

2.1.6.2 Disadvantages of Credit Rating

Disadvantages of Credit Rating are as follows: 1. Biased rating and misrepresentations: In the absence of quality rating, credit rating

is a curse for the capital market industry, carrying out detailed analysis of the company, should have no links with the company or the persons interested in the company so that the reports impartial and judicious recommendations for rating committee. The companies having lower grade rating do not advertise or use the rating while raising funds from the public. In such cases the investor cannot get information about the riskiness of instrument and hence is at loss.

2. Static study: Rating is done on the present and the past historic data of the company and this is only a static study. Prediction of the company’s health through rating is momentary and anything can happen after assignment of rating symbols to the company. Dependence for future results on the rating, therefore defeats the very purpose of risk inductiveness of rating. Many changes take place in economic environment, political situation, government policy framework which directly affects the working of a company.

3. Concealment of material information: Rating Company might conceal material information from the investigating team of the credit rating company. In such cases quality of rating suffers and renders the rating unreliable.

4. Rating is no guarantee for soundness of company: Rating is done for a particular instrument to assess the credit risk but it should not be construed as a certificate for the matching quality of the company or its management. Independent views should be formed by the user public in general of the rating symbol.

5. Human bias: Finding off the investigation team, at times, may suffer with human bias for unavoidable personal weakness of the staff and might affect the rating.

6. Reflection of temporary adverse conditions: Time factor affects’ rating, sometimes, misleading conclusions are derived. For example, company in a particular industry might be


temporarily in adverse condition but it is given a low rating. This adversely affects the company’s interest.

7. Down grade: Once a company has been rated and if it is not able to maintain its working results and performance, credit rating agencies would review the grade and down grade the rating resulting into impair ring the image of the company.

8. Difference in rating of two agencies: Rating done by the two different credit rating agencies for the same instrument of the same issuer company in many cases would not be identical. Such differences are likely to occur because of value judgment differences on qualitative aspects of the analysis in tow different agencies.

2.2 Overview of Basel II 2.2.1 Meaning and Definition of Basel II

Basel II is an international business Standard that requires financial institution to maintain enough cash reserves to cover risk incurred by operations.The Basel accords are a series of recommendations on banking laws and regulations issued by the Basel Committee on banking supervision (BCBS). The name for the accords is derived from Basel, Switzerland, where the committee that maintains the accords meets.

2.2.2Background of Basel II

In June 2004, BCBS issued a revised framework of ICCMS, introduced the famous “Three Pillar Concept” of Capital Adequacy for strengthening the risk management practices of the banking industry. Later, in June 2006, a comprehensive revision of ICCMCS was in public by incorporating Basel II Framework, June 2004, the elements of the 1988 Accord that were not revised during the Basel II process, the 1996 Amendment to the Capital Accord to Incorporate Market Risks, and the paper on the Application of Basel II to Trading Activities and the Treatment of Double Default Effects, 2005. The paper has been invariably termed as Basel-II framework. This was also supposed to be applied on a fully consolidated basis to any holding company that is the parent entity within a banking group to ensure that it captures the risk of the whole banking group. Basel-II incorporated the treatment for the activities of banking entities, securities entities, financial entities, insurance entities and commercial entities when they are subsidiaries or minority owner of any bank holding company. Another groundbreaking addition in this version of this capital accord was the incorporation of the treatment of securitization exposure for credit risk. Both traditional and synthetic securitization exposures have been accounted for consideration.

Evolution of the Regulatory Environment 1988 Basel Capital Accord 1996 Market Risk Capital Amendment 1996 – 1998 Ad hoc rules for credit derivatives Jun. 1999 Consultative Document from Basel Committee Jan. 2001 Basel Committee proposes New Capital Accord June 2004 The purpose of Basel II, which was initially published. BCBS issued a revised

framework of ICCMS, introduced the famous “Three Pillar Concept” of Capital


Table 2: Evolution of the Regulatory Environment

2.2.3The main objective of the Basel II Accord is to: Strengthen the soundness and stability of international banking systems Create and maintain a level playing field for internationally active banks Promote the adoption of more stringent practices in the field of risk management

2.2.4The Basel II Framework consists of three pillars:

1. Calculation of minimum capital requirements 2. Supervisory review 3. Market discipline (public disclosure)

Figure 1: Summary of Basel II

Pillar 1- Minimum Regulatory Capital Requirements

For the first pillar of the Basel II Capital Accord the Basel Committee proposed capital requirements associated with three categories of risk:

Adequacy for strengthening the risk management practices of the banking industry. Nov. 2005 Basel II: International Convergence of Capital Measurement and Capital Standards: A

Revised Framework June 2006 a comprehensive revision of ICCMCS was in public by incorporating Basel II

Framework

Basel II

Pillar-1 Pillar-2 Pillar-3

Minimum Capital Requirement (MCR)

o Credit Risk- Standardized Approach Foundation of IRB

Approach Advanced IRB

Approach o Market Risk- Standardized Method, Internal Model

Approach o Operational risk- Basic Indicator

Approach Standardized Approach

Supervisory Review Process (SRP)

o Bank End- Internal Capital

Adequacy Assessment Process (ICAAP)

Risk Management o Supervisory End- Evaluation of Banks’

internal systems (ICAAP)

Assessment of Risk Profile

Review of compliance with all regulations

Supervisory measures.

Market Discipline

o Transparency- For market participants

concerning bank’ risk position (scope of application, risk management, detailed information on own funds etc.)

o Comparability Between and among

the banks within the jurisdiction.


1. Credit Risk

Credit risk is the possibility of a loss as a result of a situation that those who owe money to the bank may not fulfill their obligation. The following methods can be used to determine credit risk: The Standardized Approach, The Foundation Internal Rating Based Approach and the Advanced Rating Based Approach. The Standardized Approach provides improved risk sensitivity compared to Basel I. The two IRB approaches, which rely on banks’ own internal risk ratings, are considerably more risk sensitive.

Standardized approach (credit risk)

The term standardized approach refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions.In this approach, securitized claims will also be assigned their own risk weights depending on their external ratings. Under this approach the banks are required to use ratings from External Credit Rating Agencies to quantify required capital for credit risk. In many countries this is the only approach the regulators are planning to approve in the initial phase of Basel II Implementation.

The Basel Accord proposes to permit banks a choice between two broad methodologies for calculating their capital requirements for credit risk. The other alternative is based on internal ratings.

Internal Ratings-Based (IRB) Approach

Under the Basel II guidelines, banks are allowed to use their own estimated risk parameters for the purpose of calculating regulatory capital. This is known as the Internal Ratings-Based (IRB) Approach to capital requirements for credit risk. Only banks meeting certain minimum conditions, disclosure requirements and approval from their national supervisor are allowed to use this approach in estimating capital for various exposures.

Such an approach has two primary objectives -

Risk sensitivity - Capital requirements based on internal estimates are more sensitive to the credit risk in the bank's portfolio of assets

Incentive compatibility - Banks must adopt better risk management techniques to control the credit risk in their portfolio to minimize regulatory capital

2. Market risk Market risk is the risk that the value of a portfolio, either an investment portfolio or a

trading portfolio, will decrease due to the change in value of the market risk factors.

The associated market risks are.

Equity risk, the risk that stock prices and/or the implied volatility will change. Interest rate risk, the risk that interest rates and/or the implied volatility will change. Currency risk, the risk that foreign exchange rates and/or the implied volatility will

change.


Commodity risk, the risk that commodity prices (e.g. corn, copper, crude oil) and/or implied volatility will change.

3. Operational Risk

An operational risk is a risk arising from execution of a company's business functions. Operational risk is defined in the Basel II as the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. Three different methods can be used to measure operational risk: The Basic Indicator Approach, the Standardized Approach and the Advanced Measurement Approach.

Pillar 2- Supervisory review of capital adequacy

The second pillar of Basel II is a supervisory review of capital adequacy. The second pillar

notes that national supervisors must ensure that banks develop an internal capital assessment

process and set capital targets consistent with their risk profiles. Furthermore it encourages

the bank’s management to develop risk management techniques and their use within capital

management. The supervisors are responsible for evaluating how well banks are assessing

their capital adequacy needs relative to their risks. Internal processes of the bank are subject

to supervisory review and intervention. In the Bangladesh the role of supervisor is fulfilled by

the Bangladesh Bank (BB).

Pillar 3 – Market discipline and disclosure

The third pillar of the Basel II Capital Accord is about market discipline and disclosure. The

main goal of this pillar is to promote the development of financial reporting about risks. In

this way market participants can get a better understanding of banks risks profiles and the

adequacy of their capital position by disclosure. Pillar 3 in the Basel II Capital Accord sets

out disclosure requirements and recommendations in several areas. These requirements apply

to all banks and when a bank cannot meet these requirements it can be constrained in the way

it manages capital. For example the bank may not use any of the advanced techniques under

Pillar 1.


2.2.5The significant features of Basel II

Significantly more risk sensitive capital requirements and takes into account operational risk of banks apart from credit and market risks. It also provides for risk treatment based on securitization.

Great use of assessment of risk provided by banks’ internal systems as inputs to capital calculations.

Provides a range of options for determining the capital requirements for credit risk and operational risk to allow banks and national regulators to select the approaches that are most suitable for them.

Capital requirement under the new accord is the minimum. It has a provision for supplementary capital that can be adopted by national regulators.

The Accord promotes strong risk management practices by providing capital incentives for banks having better risk management practices.

One most note that the capital requirements under Basel II do not include liquidity risk, interest rate risk of banking book, strategic risk, and business risk. These risks would fall under “Supervisory Review Process”. If supervisors feel that the capital held by a bank is not sufficient, they could require the bank to reduce its risk or increase its capital or both.

2.2.6 Basel II Implementation Scenario in Bangladesh

In2006, BB issued an action plan / roadmap. Inconsequence 2 major tasks were done Guidelines for recognition of eligible ECAI’s- September 2008, Guidelines on RBCA– a Revised Regulatory Capital Framework in line with Basel II-

December 2008.

Banks entered in Basel-II regime fully in January 2010. Capital broadly categorized in 3 parts.

Tier-1:Core Capital Tier-2:Supplementary Capital Tier-3:Additional Supplementary Capital

MCR is now 10% of RWA with 5% core capital or Tk.400 million whichever is higher (from July 2011).

BB structured its RBCA guidelines considering all propositions of Basel-II. Calculating RWA following propositions of Basel-II. Calculating RWA following approaches used

Credit Risk-Standardized Approach, Market Risk-Standardized (Rule Based)Method Operational Risk- Basic Indicator Approach.

Foundation IRBA both at Bangladesh Bank and other banks level and Parallel run along with Standardized Approach in 2012.


2.2.7 Positive and Negative Impact of Basel II 2.2.7.1Positive Impact of Basel II on banks:

The new Basel Accord i.e. Basel II will have an impact on the banking system in various ways. The implementation of Basel II provides the Indian banks an opportunity to reduce their credit risk weights as well as reduce their required regulatory capital. They can do so by suitably adjusting their portfolios. The Internal Ratings Based approach would give freedom to the individual banks by giving them the right to assess their own economic capital by taking risk into consideration resulting in a degree of regulatory restraint1. The Standardized or IRB approach will help the banks for most of its exposures, including its securitization exposures. As incentives for adopting the more advanced approaches for credit and operational risks, banks are anticipated to experience lower capital requirements and therefore lower costs under these approaches (Francis, 2006). Basel II aligns economic risk more closely with regulatory risk. This will make it easier for the banks to lend to corporate, increase their retail lending and provide mortgage under loans with higher margins (crockett, 2005). It will change the treatment of credit risk ensuring that banks have sufficient capital to cover operational risk. It will lead to an improvement in the risk measurement assessment thereby giving banks an opportunity to gain competitive advantage by allocating capital to those processes segments and markets that demonstrate a strong risk return ratio. Another benefit that banks would get from Basel II is a better understanding of risk return trade off for capital supporting specific business, customer products and processes. Some of the other advantages that the banks would enjoy by implementing Basel II would be that the strong risk management process will help them to serve the customers better and also the small and medium sized business will get liquidity into the portfolio, helps in collateralizing and hedging2. The Pillar 2 of Basel introduces the concept of economic capital which will help the banks to determine capital adequacy based on the level of risk and required capital thereby reducing arbitrage opportunity. It also provides incentives for banks to transfer credit risks through instruments such as asset-backed securities or credit derivatives, while retaining the customer relationship3. Basel II will also provide banks with businesses benefits by improving corporate governance, improving allocation of capital, the risk based pricing will help to improve the competitiveness, capital saving, better decision making will allow counter parties to deal and enhancing the value of stakeholders (Oosthuizen, 2005). Basel II will give the banks different options from which they can choose like large banks are expected by the market and supervisors to apply advanced risk management methods. A bank with non-complex operations may use a simple and less expensive system. Basel II is drafted flexibly in order to incorporate future changes such as new financial instruments, new activities and so on, can be incorporated without having to change the basic structure.

1.(www.ibase.br/userimages/FLGG%20-20Chalapurath%20Chandrasekhar.pdf) 2.(www.us.kpmg.com/microsite/FSLibraryDotCom/docs/Basel_AWorldwide%20Challenge_web%20(2)) 3.(www.us.kpmg.com/microsite/FSLibraryDotCom/docs/Basel_AWorldwide%20Challenge_web%20 (2)).


Banks will get a higher degree of freedom in the way they operate or may operate in the future, but has some built-in restraints to ensure at least a basic level of capital, such as minimum floors on the capital requirements (Lind, 2005). Some of the other benefits of Basel II would include a more active portfolio management and forward looking risk assessment in which there would be more activeness in portfolio risk management by access to timelier and higher quality risk information and by differential capital requirement. The pricing of risk will be more proactive and there would also be an improvement in performance management.4

2.2.7.2Negative of Impact Basel II on banks:

The banks in Bangladesh that would be applying Basel II will have to face certain drawbacks as well. The Basic Indicator approach specifies that banks should hold capital charge for operational risk equal to the average of the 15 per cent of annual positive gross income over the past three years, excluding any year when the gross income was negative. Also the capital required by the bank would depend on the level of bad debt it has or the non performing asset lying with it. The preference of banks for government securities and the increased risk-aversion of banks following the adoption of Basel II would adversely affect credit to agriculture and small scale industries1. Banks which will not be adopting Basel II will not face its compliance challenges but may nonetheless is pushed to use it as a competitive benchmark. Regulators have to face a challenge as they have to provide a level playing field in their jurisdiction and internationally as the Basel Committee's recommendations are implemented by legislatures in various countries. In addition, they have to ensure that their examiners are adequately trained to assess bank's compliance with the new capital rules.2

Medium-sized national banks which have limited international presence will have to think hard about their credit ratings systems, given that credit risk remains the main part of their total risk. Most will initially adopt the simpler Standardized approach to measuring credit risk. Others will adopt the IRB Foundation approach indicating that banks with major retail business might well expect significant capital reductions when applying the IRB Foundation approach. Small banks might face the problem that the implementation of Basel II requirements and the development of internal credit rating systems will turn out to be costly for them. But without a credit ratings system of some kind it will be difficult for them to price their loans competitively. Therefore, it may be out of reach for many smaller banks. It is very unlikely that these banks will have the financial resources, intellectual capital, skills and large scale commitment that larger competitors have to build sophisticated systems to allocate regulatory capital optimally for both credit and operational risks.

4.(www.kpmg.com.mx/gobiernocorporativo//libreria_gc/rrr/Basilea%20II/basel_ii.pdf) 1.(www.ibase.br/userimages/FLGG%20-20Chalapurath%20Chandrasekhar.pdf) 2.(www.us.kpmg.com/microsite/FSLibraryDotCom/docs/Basel_AWorldwide%20Challenge_web%20 3.(http://www.globalriskregulator.com/archive/May2003-06.html)


2.2.8 Role of Rating Agencies under Basel II

As required by the Capital Requirements Directive (CRD), European authorities have considered whether the methodologies of the three external credit assessment institutions (ECAIs) meet the requirements of objectivity, independence, ongoing review and transparency and that their ratings meet the requirements of credibility and transparency. Furthermore they have considered which of the 'risk weights' should be attached to their ratings (the 'mapping').

2.2.9 Problems in Developing Countries: As Bangladesh is a developing country it can come across various problems in implementing Basel II. The capital regulation that Basel II requires is a matter of concern that whether it will ensure systematic banking stability or not. Even the currency mismatch which is a major threat to banking is appropriately mentioned in Basel II or not. Then Basel II might reduce the bank credit levels to developing economies both internationally and nationally. It could be worse for poorer countries and those with low perceived creditworthiness. This could reduce their investment, demand and future growth. Developing countries have a greater percentage of lower rated borrowers. The IRB approach has a lesser incentives to lend to such borrowers. This, along with withdrawal of uniform risk weight of 0% on sovereign claims may result in overall reduction in lending by internationally active banks in developing countries and may increase their cost of borrowing. Moreover, the concern is whether Basel II would increase pro-cyclicality of bank lending, both domestically and from international banks. This would increase volatility of growth and investment, as well as increase systemic risk in the banking system. Moreover, the introduction of Basel II could discourage particularly lending to Small Medium Enterprises (SME’s) and to other sectors or modalities crucial for growth, employment and investment (Jones, 2007). 2.3 Matrix of Participants in the Basel Process Public Private Mixed Supranational G10, G20, G77,

European Union, BIS, BCBS, Basel Senior Supervisors Group, Financial Stability Board, IMF, World Bank, IOSCO, IASB, FASB

“Core banks”, the financial markets, hedge funds, “financial engineers”, financial risk analysts, credit rating agencies, mass media

Banks and investment firms; risk management and credit rating agencies and professional Economists. The G30 and IIF

National Executive branch, finance ministries, central banks, financial regulators, legislatures and subcommittees,

Large national banks and corporations, pension funds, insurance industry, industry associations and lobbyists

Federal Reserve Bank of New York, “Government- Sponsored Enterprises”

Sub-national State banking Supervisors

Community banks, private citizens

Table 3: Matrix of Participants in the Basel Process


Basel is an example of multilevel governance. It involves supranational institutions (Bank for International Settlements, the Basel Committee), central banks, finance ministries, multiple overlapping financial regulators, industry lobbyists, legislative bodies with oversight powers, transnational governance structures (regulators working across state boundaries to develop new regulations), and transnational interest groups. The Bank of International Settlements (BIS) was established by central banks in 1930 in Basel, Switzerland as “the central bankers’ central bank”. It was initially intended to serve as a clearinghouse of information shared between central banks overseeing the repayment of Germany’s reparations from World War I. Since then, the BIS has grown into the institutional setting in which central bankers can address issues of concern to their individual economies and the global economy. The Basel Committee on Banking Supervision (“Basel Committee” or BCBS), comprised of twenty-seven countries, conducts its work under the review of its oversight body, the Group of Central Bank Governors and Heads of Supervision of its member jurisdictions. The Financial Stability Board also works closely with the Committee.

The dominant function of modern independent central banks is to control the national money supply. Whether central banks should simultaneously act as regulators of their local banking systems is not a universally agreed function. Felsenfeld surveyed thirty countries and concluded that twenty do not give their central banks regulatory responsibilities. The central bank of the United States does regulate a major share of the American financial system including national banks and all bank holding companies.

England has gone the other way with the Central Bank of England performing regulatory functions until they were taken away in 1997 and given to the newly formed Securities and Investment Board (now Financial Services Authority). Debate over the independence of central banks has not been settled, although independent central banks have spread around the globe. When economic conditions become dire, the power of the central bank increases as the need to “rescue” the economy increases and the central bank steps into the role envisioned as the “lender of last resort.” Indeed the Global Financial Crisis has shown the extent to which the Fed has the authority to act as “lender of last resort” not only to commercial banks but to investment banks, insurance companies, and other businesses under a provision of a 1932 federal law concerning “unusual and exigent circumstances”. [Basel II implementation guideline]

“Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation” – A Review on Bangladesh Context; C

Chapter # 03 CREDIT RATING

SYSTEMS

3.1 Credit Rating Systems or Modus Operandi of WCRCL

3.2 Mapping Comparison


3.1 Credit Rating Systems or Modus Operandi of WCRCL (Figure 2)

Client WCRCL Ratings Operational Independence

Rating Request to WCRCL

Initiation of Confidentiality Clause

Mandate of Authorized Persons

Interaction with Rating Team,

Responds to Queries, Provide Information &

Support to Analysis

Ensuring the Facts & Figures in the Draft Report and also for

Rating Analysis

Yes

Accepts Rating?

No

Acceptance of Mandate

MOU with Client Including Confidentiality Agreement

Analyst Team Formation

Interaction with Client, Collect & Collate Information, Undertake Site

Visit and Others

Analysis of the Information, Preparation of Draft and Submission to

Internal Review Committee (IRC)

Review of IRC and Collection of Additional Information, If Necessary

Issue of Draft Report without Rating to Client & Finalization of the Draft

Report

Placing To Rating Committee the Accepted Draft, Detail Analysis and

Also the Comments from Clients

Rating Committee Awards Rating And Rating Release To Client with Rating

Rationale

Issue of Rating Report with Rating Rationale

Press Release, Publish on the WCRCL Website

Business Team

Operations Team

Compliance Team


3.2 Mapping Comparison

The mapping of rating scales of CRISL, CRAB, NCRL, ECRL and ARGUS with BB rating grades has already been specified in the Guidelines. Now, the rating scales of CRISL, CRAB, NCRL, ECRL, ARGUS and WCRCL have been mapped with BB rating grades as given below:

Long Term Rating Category Mapping BB’s Rating Grade

Equivalent Notch/Notation of CRISL

Equivalent Notch/Notation of CRAB

Equivalent Notch/Notation of NCRL

Equivalent Notch/Notation of ECRL

Equivalent Notch/Notation of ARGUS

Equivalent Notch/Notation of WCRCL

1

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 A1, A2, A3 A+, A, A A+, A, A A+, A, A A+, A, A 3 BBB+, BBB, BBB BBB1, BBB2,

BBB3 BBB+, BBB, BBB

BBB+, BBB, BBB

BBB+, BBB, BBB BBB+, BBB, BBB

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

5 B+, B, B- CCC+, CCC, CCC- CC+, CC, CC-

B1, B2, B3 CCC1, CCC2, CCC3 CC

B+, B, B- B+, B, B- B+, B, B- B+, B, B-

6 C+, C, C-, D C, D C+, C, C-, D C, D C+, C, C-, D C+, C, C-, D Short Term Rating Category Mapping

S1 ST-1 ST-1 N1 ECRL-41 ST-1 P1 S2 ST-2 ST-2 N2 ECRL-2 ST-2 P2 S3 ST-3 ST-3 N3 ECRL-3 ST-3 P3 S4 ST-4 ST-4 N4 ECRL-4 ST-4 P4 S5, S6 ST-5, ST-6 ST-5, ST-6 N5 D ST-5, ST-6 P5&P6

Table 4: Mapping Comparison

Basel II Implementation Cell, Banking Regulation and Policy Department, Bangladesh Bank.www.bb.org.bd

“Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation” – A Review on Bangladesh Context; D

Chapter # 04 Credit Rating Methodology

4. Rating Methodology 4.1 List of Rating Methodologies in BD ECRA’s 4.2 Corporate Rating Methodology 4.2.1 Diagram of Corporate Rating Methodology 4.2.2 Comparison among the Methodologies of Different ECAI’s 4.3 Banks and Non-Banking Financial Institution Rating Methodology 4.3.1 Diagram of Banks and NBFI’s Rating Methodology 4.3.2 Comparison among the Methodologies of Different ECAI’s 4.4 Small Medium Enterprises (SMEs) Rating Methodology 4.4.1Diagram of SMEs Rating Methodology 4.4.3 Comparison among the Methodologies of Different ECAI’s 4.5General Insurance Rating Methodologies 4.5.1Diagram of GI’s Rating Methodology 4.5.3 Comparison among the Methodologies of Different ECAI’s 4.6 WCRCL Rating Scales & Definitions


4. Rating Methodology The specific insights of each sector (qualitative and quantitative factors, such as appraisal of the historic and projected financials, level of profitability, capacity utilization, capital expenditure need, and cash flow adequacy, debt servicing capacity, free cash flow, and time series analysis) are converted to specific traits with appropriate weightage for highest performance, lowest performance, industrial average etc. to arrive at a meaningful rating of an organization.

Figure 3: Rating Methodology (Source: CRAB)

LOCAL CURRENCY DEPOSIT CEILING (AAA-C)

LOCAL CURRENCY DEPOSIT CEILING (AAA-C)

FINANCIAL STRENGTH RATING (A-E)

BASELINE RISK ASSESSMENT (Aaa-C)

LOCAL CURRENCY DEPOSIT/ DEBT RATINGS (Aaa-C)

FOREIGN CURRENCY DEPOSIT/DEBT RATINGS (Aaa-C)

Probability of National Government Support

Other External Support Factors

INTRINSIC FACTORS EXTERNAL FACTORS


4.1 List of Rating Methodologies in Bangladesh Credit Rating Agencies CRISL methodologies cover followings sectors:

Bank and Financial Institutions Merchant Banks Microfinance Institutions Manufacturing Corporate General Insurance Securities Firm Airlines Life Insurance

Asset Backed Securities Bank Loan / Facility Rating Government Support Entities Investment Company Trading Concerns Telecommunication SME (Small Medium and

Enterprise)

CRAB rating methodologies are as follows:

1. Bank Rating Methodology 2. Financial Institution Rating Methodology 3. Corporate Rating Methodology 4. General Insurance Rating Methodology 5. Life Insurance Rating Methodology 6. Government Owned Enterprise Rating Methodology 7. Securitization Rating Methodology

NCRL Rating Methodology

Corporate Rating Methodology Financial Institutions Rating Methodology (Bank & NBFI) Bank Loan Rating Methodology Brokerage Rating Methodology Insurance Company Rating Methodology (General)

Emerging Credit Rating Methodology

A. Corporate Debt Rating

1. Rating Process for Construction Companies 2. Rating Process for the Telecommunication Industry 3. Rating Process for the Oil & Gas Industry 4. Rating Process for Plantation Companies 5. Rating Process of Automotive Industry 6. Rating Process for Homebuilders

B. Financial Institution Rating

1. Rating Process for Financial Institutions 2. Rating Process for Financial Holding Companies 3. Rating Process for Islamic Financial Institutions

C. General Insurance


D. Life Insurance E. Project Finance F. Issuer Debt Rating G. Rating Process Govt. Agencies H. Bond Rating

In this chapter I have tried to discuss the corporate rating methodology, Banking and Non-Banking financial institution rating methodology, small and medium enterprise (SME) rating methodology and general insurance rating methodology performed by different ECAI’s in Bangladesh with highlighting their diagram and comparison among theme.


4.2 Rating Methodology (Corporate/Manufacturing Corporate)

A. Industrial Risk

1. Regulatory framework: Regulatory framework has direct impact on the industry and to the firms operating under the industry. The regulatory framework of the industry in most cases are dictated by the government industrial policy, annual budgetary frame work and measures including tax holidays, cash incentives, labour laws, environmental compliance issues and even by the import policy of the government and sometimes also been influenced by external factors such as buyers requirements from abroad, WTO Commitment of the government etc.

2. Industrial Risks: Risk is inherent in all industrial firms. Risk assessment in manufacturing units begins with an understanding of their operating environment. The operating environment dictates the factors to be taken into account while evaluating its long term performance and its possible impact on the cash flow, profitability and ultimately repayment capacity. The operating performance of industrial units is affected by trend of various economic variables including GDP, interest and exchange rates and nature of the industry. In addition, pattern of demand growth, elasticity of demand, inherent risk in manufacturing, unstable power supply, small and unstable market, entry of advance technologies plays an important role in evaluation.

3. Growth potentials: Growth potential of a firm vis-à-vis its industrial growth plays an important role in CRISL analytical rating framework. The industry life cycle such as introductory stage, growth stage, maturity stage and sunset stage, all deserves a weightage in analysis. However, the above potential is always reviewed in the context of future risks potentials. Again the matured industries are not over risk weighted in view of maturity rather the factors such as business stability gets due priority vis-à-vis its other peripheral factors.

4. Vulnerability: The vulnerability of the industry through controllable and uncontrollable factors are considered in the analytical framework of CRISL the degree of sensitivity of demand to economic cycle, change in government policies such as import policy, industrial policy, tariff policy etc are the key elements to be considered in rating an industrial unit. The volatility of prices of raw material may also create a vulnerable situation for the industries. The political influence on the trade unions effecting labour intensive industries such as garments, are susceptible to vulnerability.

5. Industrial Cyclicality: Cyclical companies are those manufacturing units such as sugar, cotton spinning, automobiles paper and pulp etc whose sales in volume moves with the macroeconomic fundamentals and the operation of which needs different volume of resources as it moves with cycle. CRISL analytical framework considers the high and low picks of the cycle and gives due weights to the factors at each stage of cycle and tries rates through the cycle. Under the above circumstances CRISL ratings are forward looking. Normally the companies in cyclical industries accumulates cash and creates buffer during the boom period in order to keeping the company in smooth operation during the down turn


6. Entry Barrier: Strong restriction on the new entrant in the industry protects the interest of the existing companies and viewed as plus point while keeping the industry open for anybody may at any point of time take away the share of the existing companies and ultimately poses a threat for survival or profitable operation. However, CRISL considers that the strong prohibition factors such as huge capital outlay, creation of franchise value and brand image of the products needing time, Government restriction, distribution net work etc.

7. Size of the industry: Size of the industry on the economy and the size of the companies operating under the industry play an important role in analyzing long term and long term viability. Large companies have greater tenacity and staying power due to their extensive resource base and stronger shields. Those companies also enjoys broader market access, larger market share, strong marketing network, franchise value which ultimately assist the company’s long term viability.

8. Threats of product substitution: -Availability of substitute at cheaper price or availability of substitute products at the door step may intensify the competition. CRISL analysis inter alia considers existing and potential substitutes that may stand as threat to the existing products of the company. In addition alternative uses of the products are also explored to have an understanding under distress situation.

B. Business Risk Analysis

Under the business risk analysis CRISL evaluates the issuer’s business model, business strategies and competitive strength in the industry. Again business risk can be classified in two sub sector Market Risk and Operational Risk.

i)Market Risk

1. Competition: The nature of competition varies from industry to industry. However the product lines and its market share determines the nature of competition an organization may face. In order to survive in the competition, the cost efficiency in production and quality of product at competitive price is essential. Presently competitive advantages are being created through strong infrastructure build up and supply chain which are given due weight in the analytical process.

2. Market position, size and Age of the Business: Market share, size and age of the organization play an important role in deciding on the competitiveness of a company. Size of an organization assist in achieving economy of scale, determining economic order size, cost efficiency and thereby lowering the unit cost of production. The size of an organization also justifies the research expenditure and capital intensive equipment, effective distribution channel and branch network.

3. Product demand: Product demand in the market is a very important factor in the process of ascertaining the market stability and future growth. In this connection CRISL reviews the plant capacity utilization and quantity of production compared to the market demand, seasonality of the product demand etc are critically reviewed.


4. Product and Service diversity: In a highly competitive environment more particularly in the industries having frequent change in technology, product diversity and scope of switchover to other alternative products with small or no cost is considered to be a favorable point in the overall rating process. In the rating process, the diversity is considered to be mitigating factor against concentration risk. Companies having more product lines are always preferred to the companies dependent on single product or product line.

5. Customer Analysis: The number of customers occupying large portion of receivables, customer concentration, company reliability on few customers, capacity of the company to absorb the shock of switching over to new customer, impact of customer shifting to other competitors are reviewed by CRISL in its analytical exercise. Dependence on the customers in various market segments such as Domestic vs. export market, whole sale vs. retail market, distribution channels, long term sales contract, impact on market due to change in price all are given due weightage while carrying out customer analysis.

6. Customer satisfaction: CRISL reviews customer satisfaction of an organization in order to ascertain the market continuation and market growth. Customer satisfaction can be reviewed by average continuation of a customer with the company, repeat orders, product rejection rate etc.

ii) Operational Risk

1. Plant location and production facilities: Plant facilities, technology and plant location counts significantly in reviewing a manufacturing company. Location of an export oriented company in the export processing zone or near to that or access to easy communication is considered to be advantageous while the location of a company requiring heavy raw material or selling heavy products in the port side or river side involving cost effective transportation is considered to be a positive factor. Excess to low cost utilities facilities such as gas and water and electricity is given due weightage.

2. Availability of Raw material: Availability of raw material either from local market or export market plays an important role in the rating process. In case of local supply, the supply chain, sufficiency in terms of quality, no of suppliers, seasonality, price fluctuation, lead time and case of import, additional factors such as import policy, the government duty structure, import restrictions, cash incentive considerations all plays important role in the CRISL analytical process

3. Technology vs. Asset efficiency: Modern technology provides competitive edge over old technology. Asset composition, balanced equipment for maximum production efficiency all plays positive role while old and outdated technology reduces competitiveness having a negative impact on rating

4. Cost Structure: Cost structure plays an important role in the industrial production. CRISL classifies the cost into direct material, direct labour and overhead. Again cost accumulation and it allocation to various products through job order costing system, or process cost system is reviewed in order to arrive at a meaningful cost efficiency analysis.


Product wise contribution margin cost inefficiency arising out of unplanned expenditure, peer comparison cost, labour availability, labour sensitivity, cost components, direct cost as percentage of overall cost, all are reviewed in the rating process

5. Credit Controls: Credit control policies and its effectiveness play an important role in the liquidity management of the manufacturing companies. It is more particularly important when a company has been manufacturing for the local market. In order to maintain cash operating cycle to order for raw materials, payment of labour and factory operation, the companies require cash constantly from the business cycle. In case of export oriented manufacturing companies, the Status of payment terms of the export LC vis-à-vis back to back LCs needs review to assess the funding mismatch.

6. Inventory management: Inventory management plays a vital role in the working capital management of manufacturing companies. Excess inventory increases the holding cost and thus increase the working capital need while inadequate inventory leads to production stop or excess production cost. CRISL reviews inventory planning, supply chain management, lead time, economic order quantity etc in addition to the risk of getting the finished products out of fashion , risk of expiry date etc.

C. Financial Risk:

Every business decision ultimately leads to a financial decision. While the financial risks are the outcome of the business risk and activities, CRISL reviews the same from the perspective of short-term and long term financial planning and projections vis-à-vis financial flexibility to meet emergency financial need. CRISL generally reviews the audit reports in order to ascertain as to its reliability from various perspectives. However, in many cases CRISL reviews the financial statements from the view point of cash flow trend, management reports, peer analysis based on quantitative production/activity reports. Accounting systems/ practices, measurement system, inventory valuation, depreciation methods, quality of audit and auditors comfort level, audit qualification, management report of the auditors, application of international accounting standards in accounting plays an important role in CRISL financial analysis.

1. Profitability and coverage: Although the absolute profitability figures such as Earning (profit) before Tax and interest,(EBIT), Return on equity, return in investment etc, CRISL puts due weight to profitability indicators, profitability trend vis-à-vis industry norms, position of a particular company in the peer.

2. Funding structure: Funding structure of an organization may have an impact on its cash flow and mismatch is cash generation. CRISL places due importance to the financing pattern of long term and short term assets vis-à-vis the short term and long term debts. For example, if the long term investment in machinery is financed by working capital loan or short term finance it may seriously affect the cash flow of the company. The companies having excessive short term debts may face cash shortage in meeting its obligations in the volatile economy. In addition, dependence of the company on financial intermediaries such as leasing companies for short term fund may also face liquidity


problem in the economic volatile situation. CRISL also ties up the asset life with its financing pattern. Any machinery purchased through lease must not have any repayments after the machinery life is exhausted.

3. Capital Structure / leverage: Capital structure of an organization varies from industry to industry. Capital intensive industries require high leverage while the labour intensive industries work at low leverage. CRISL identifies industrial norms in respect of debt equity ratio, coverage ratios, overall gearing ratio, interest coverage ratio, debt servicing coverage ratio in order to measure the degree of leverage. CRISL also reviews the off balance sheet assets and liability items such as guarantees, LCS together with BB LCS in order to ascertain its leverage.

4. Cash flow stability and adequacy: Cash flow of a company plays a very important part in CRISL assessment procedure. CRISL in many cases reads the Financial Statements with due emphasis to cash flow. To CRISL Cash flow balance sheets rather provides more reliability of financial statements than normal statements. Stable cash flow provides comfort of judging the capability of the company to discharge its liabilities while free cash flow predicts company’s ability to go for expansion or loan repayment capacity or business growth.

5. Financial flexibility and liquidity: Liquidity is the key to judge the short term financial flexibility of a company. In addition the franchise value of the company to borrow quick fund from the market, relationship with the financial institutions, level of financial limits allowed by the banks and its utilization level, perception of the financial institutions for funding projects under the company, cash operating cycle etc provides wider coverage to the CRISL analysis.

6. Financial Management: CRISL rating analysis places due weight to the quality of financial management. Managing Finance through budgetary control system, working capital management through budgetary control system, management of cost efficiency through installation of appropriate cost accounting system, product costing , use of accounting information by the management, IT base financial management system, quality of the manpower and their qualification etc all are taken into consideration while ascertaining the extent of financial management.

D. Governance Risk

1. Corporate goals and strategy: Although the Memorandum of Association of the company contains a large number of objectives, the company normally pursues one or two main objectives on the basis of which the MISSION and VISION Statements are prepared in order to determine the corporate goals. Companies operating on the basis of certain corporate goals as reflected in operating activities.

2. Corporate Governance: Corporate governance is a blend of law, regulations, enforcement and appropriate voluntary practice by the organizations that permit a corporate to attract capital, perform efficiently and generate long term economic value for its shareholders while respecting the interest of its stakeholders and society as a whole. The specific areas covered


are composition of Board, formation of Committees, transparency in disclosure of relevant, reliable financial and operational information, information on ownership and control and information on internal processing of management. CRISL places due importance to the governance factors in the rating process of an organization.

3. Succession planning/ Family owned outfit: The succession plan is the key indicator of corporate philosophy that an organization is a going concern and it has unlimited life and its viability will not be affected on the departure of any individual professional. In order to reduce the dependency on single/few individuals a succession plan in a corporate reflects the management idea of business management continuity and its succession. CRISL while reviewing the management philosophy takes into consideration of the above factor. In addition, through the succession plan, the visibility of family management vs. professional management becomes more prominent.

4. Credibility and Banking Relationship: Credibility, to a great extent, may be reflected in its franchise value and public perception in the market. However, in order to identify the willingness of the company to discharge a liability in time, CRISL philosophy is to see the corporate environment prevailing in the organization vis-à-vis the strategy being followed to achieve the corporate goals through managing its diversified business. In addition, corporate policy to management of conflict of interest, handling intercompany transfer pricing and intercompany transactions also reflects the credibility of the organization and its system. In addition to the above, banking relationship plays important role to judge the credibility of an entity. CRISL carefully looks into all the exposures of the entity enjoyed from the bank/FIs along with length of relationship. CRISL also reviews the utilization limit of credit facility. Besides, the personal deposit of the key sponsors, if there is any, are also taken into consideration. While reviewing the credit facilities, CRISL also look into the present status of the same along with past performance.

5. IT Infrastructure: The extent of Information technology and communication infrastructure installation and the extent of its use in the production and product management, cost management, inventory management play an important role in managing an organization. CRISL review process places due importance to the above factors in order to ascertain the competitiveness in both local and international market.


4.2.1 CRABs Corporate Rating Methodology

Figure 4: Corporate Rating Methodology

CRISL follows sequential steps in the total assessment process as below:

Client (MFI) CRAs

Request for Ratings (Time frame for each level)

> The CRISL team formally asks for primary information through a set questionnaire with a given time frame of one week.

Submits detailed information > The team collects, collates and analyzes information from the client and identifies the gaps of further information from market and client.

Interacts with the team, responds to queries, provides any

> • The team interacts with clients, visit site and analyzes data submitted by the client. • Organizes interview with different levels officials of the organization. • Team members interact, exchange views among them and prepare report for Internal Review Committee (IRC) and IRC forwards a summary report without rating rationale and symbol.

Reviews the summary report of IRC and suggest revision if any and provides additional information if they consider necessary

> IRC further reviews the report with the additional information from the client and submits final report to Rating Committee with the indicative rating.

Table 5: Sequential steps in the total rating assessment process

Industry Risk Analysis

Business Risk Analysis

Security Risk Analysis

Operating Environment

Strategy and Financial Policies

Management Evaluation

Corporate Governance

Relationship Risk Analysis

Operating Performance

Financial Strength

Generic Rating Factors

Corporate Rating

Input Output


4.2.2 Comparison among the Corporate Rating Methodology of Different ECAI’s PARTICULARS CRISL CRAB NCRL ECRL WCRCL ALPHA Industry Risk Analysis

Regulatory framework; Industrial Risks; Growth potentials; Vulnerability; Industrial Cyclicality; Entry Barrier ;Size of the industry; Threats of product substitution;

Labor market constraints or incentives, Strength and Political Direction of labor unions; labor cost and strike experience; condition of general infrastructure (water, electricity, oil, gas, roads, ports, airports, etc.); Accounting and reporting transparency; regulatory risk; taxation; corruption.

Demand supply factors, price trends, changes in technology, international/domestic competitive factors in the industry, entry barriers, capital intensity, business cycles etc

Business Risk Analysis

Market Risk Competition; Market position, size and Age of the Business; Product demand; Product and Service diversity; Customer Analysis; Customer satisfaction. Operational Risk Plant location and production facilities; Availability of Raw material; Technology vs. Asset efficiency; Cost Structure; Credit Controls; Inventory management

Size and scale; business model, competition, diversification.

Market share; Diversification; Size; Seasonality and Cyclicality; Cost Structure; Marketing and Distribution Arrangements

Industry/Operating Environment; Competitive Position; Operations Analysis

Industry Risk; Market Position; Operating Efficiency; Size of Business

Industry Outlook

Competitive Position

Operations Analysis


Financial Risk Analysis

Profitability and coverage; Funding structure; Capital Structure / leverage; Cash flow stability and adequacy; Financial flexibility and liquidity; Financial Management

Strategies and plans; acquisition strategies; financial policies; working capital management

Cash Flow Capital

Structure Financial

Flexibility

I. Profitability and Earnings Ratios II. Cash Flow and Coverage Ratios III. Leverage Measures IV. Short Term Debt Servicing Ability/Liquidity

Accounting quality; Earnings potential/profitability ; Cash flows analysis; Financial flexibility

Earnings; Cash Flow Generating Ability and Debt Servicing Capacity; Capital Adequacy; Financial Flexibility

Management/ Ownership/ Governance Risk Analysis

Corporate goals and strategy; Corporate Governance; Succession planning/ Family owned outfit; Credibility and Banking Relationship; IT Infrastructure; Environmental and Legal Issues.

Ownership Organization

Structure Willingness and

ability of the corporate;

Bankers confidential report;


Systems & Control

Organizational structure

Performance of Group Companies

Security Risk & Relationship Risk

Complexity of the corporate structure; Organization structure, management breadth and experience; Management flexibility in responding to competition, track record of management; Management continuity; Strategy and execution; Financial risk tolerance; Corporate governance; Ownership.

Management Evaluation; Geographical Analysis; Regulatory and Competitive Environment; Fundamental Analysis

What businesses to be in, what strategies should be pursued, and how these activities should be financed; Management evaluation; Risk management principles and practices.

Table 6: Comparison among the Corporate Rating Methodology of Different ECAI’s


4.3 Financial Institutions Rating Methodology (Bank & NBFI)

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

The Analytical Process

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

Quantitative Factors

A) Capital Adequacy: Capital Adequacy is a measure of the degree to which the bank’s capital is available to absorb possible losses. It also indicates the ability of the bank to undertake additional business. NCR examines the conformity of the bank to the regulatory guidelines on capital adequacy ratio. The size and the composition of the regulatory capital, internal capital generation, minimum capital adequacy requirement, stability of capital adequacy ratios and the presence of the hidden reserve are reviewed. A higher proportion of core capital (tier-1) in the total capital is viewed positively.

B) Asset Quality: Asset quality is the measure of Banks/FIs ability of managing credit risk. In reviewing the asset quality, NCR places due importance to Banks /FIs credit Appraisal mechanism portfolio management system rescheduling philosophy etc. in addition we also examine the structure of the bank’s balance sheet, including the relative proportions of different asset categories. In this context, we ask for a breakdown of lending by type of loan, size, maturity, currency, economic sector & geographical distribution. We also look at concentrations of credit risk, including large exposures (generally over 10% of equity) to individual customers & credit risk concentrations in particular industries. Banks are taking on increasing off-balance sheet commitments, & it is important to analyze the risks involved. Such commitments include guarantees & letters of credit as well as derivatives.

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


compares the Bank’s performance on each of the above parameters with its peers. Analysis is carried out to identify the relative position of the Bank in its present operating environment.

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

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

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

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

Qualitative Factors

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

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

i. Credit risk: NCR evaluates all the credit risks arising from on balance sheet activities as well as off balance sheet commitments. We examine the structure of the Bank’s Balance Sheet, including the relative proportions of different asset categories. Generally, loans and


advances constitute the most significant portion of assets of a commercial bank and therefore a comprehensive review of the credit portfolio is essential for the assessment of the credit risk. NCR classify the loans and advances by type of loans, size, maturity, economic sector and geographical location. With reference to the other assets, we analyze the general quality of the securities, their maturity, any undue concentration and the valuation of these securities.

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

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

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

C) Management Quality: A well defined management structure is an important ingredient for the success of a bank. The composition of the board, frequency of change of CEO and the organizational structure of the bank are considered. NCR looks at the dependence of management team on one or more persons, coherence of the team, and the independence of the management from major shareholders. The bank’s strategic objectives and initiatives in the context of resources available, its ability to identify opportunities and track record in managing stress situations are taken as indicators of managerial competence.

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


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

F) Accounting Quality: Rating depends profoundly on audited data. Policies for income recognition, provisioning and valuation of investments are examined. Suitable adjustments to reported figures are made for consistency of evaluation and meaningful interpretation.

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

4.3.1 Diagram of CRABs Bank Rating Methodology

Figure 5: CRABs Bank Rating Methodology

Profitability

Earnings and Volatility

Liquidity and Funding

Asset Quality

Capital Adequacy

Earning Diversification


Investment quality

Control & Risk Management

Asset Quality & Provisioning

Sectoral Adjustment

Bank Financial Strength Rating

Input Output


4.3.2Banking and Non-Banking Financial Institutions Rating Methodology PARTICULARS CRISL CRAB NCRL ECRL WCRCL Quantitative Factors

A) Capital Adequacy B) Asset Quality C) Earning Prospects D) Liquidity and

Funding E) Size of the Bank/ FI

& Market Position F) Capacity of

External Fund Mobilization

A) Capital Adequacy B) Capitalization C) Liquidity and

Funding

A) Capital Adequacy B) Asset Quality C) Earnings Quality D) Liquidity E)Competitive Position; F) Size and Market Presence

A) Capital Adequacy

B) Asset Quality C) Earnings D) Liquidity and

Funding

A) Capital Adequacy i) Size of Capital ii) Quality of Capital Components iii) Sustainability of Capital Ratios iv) Capital Vs. Business Growth Plans

B) Asset Quality i) Geographical Diversity and Sectoral

Diversity ii) Profile of the Large Exposures

iii) Quality of Non Industrial/Specialized Lending

iv) NPA/Weak asset Levels v) Growth in Advances

C) Earnings Potential D) Liquidity/ Asset Liability

Management E) Market Position

Qualitative Factors

A) Management B) Corporate Governance C) Application of Information Technology D)Regulatory Environment and Compliances E)Basel-II Compliances F)Risk Management & Sensitivity To Market Risk G)Accounting Quality Franchise Value

A) Franchising strength and Diversification

B) Management Evaluation

C) Corporate Governance

D) Controls and Risk Management

E) Risk Positioning F) Operating and

Regulatory Environment

A) Risk Management i. Credit risk: ii. Market risk: iii.Operational risk: B) Ownership and Support C) Management Quality D) Corporate Governance E) Compliance with Statutory Requirements F) Accounting Quality G) Franchise Value

A) Management B) Sensitivity to

Market Risk or Risk Management

A) Management Evaluation i) Goals and Strategies ii) Systems and Monitoring iii) Risk Appetite iv) Competence and Integrity

B) Resource Raising Ability i) Size of Deposit Base ii) Deposit Mix iii) Growth in Deposit Base iv) Cost of Deposits v) Diversity of Investor Base

C) Regulatory Compliance D) Risk Management E) Franchise Value F) Government Support

Table 7: Banking and Non-Banking Financial Institutions Rating Methodology


4.4 Small Medium Enterprises (SMEs) Rating Methodology

The Bangladesh Rating Agency Limited (herein after referred to as “BDRAL”) rating frameworks considers a number of financial and non financial parameters of the enterprise and regulations and industry specific dynamics. BDRAL believes that the industry in which a SME operates has a direct bearing on the overall performance of the SME and therefore rates SMEs based on industry benchmarks. BDRAL Rating is a comprehensive assessment of the enterprise taking into considerations the overall financial and non-financial performance of the subject company vis-à-vis the other peers in the industry in the same line of business and size criteria. Based on its assessment and understanding BDRAL has developed rating methodology framework which mainly addresses the following areas

A) Industry Risk The industry in which an enterprise operates plays a crucial role in the credit risk assessment. It is a key determinant of the level and volatility in earnings of any business.

B) Business Risk Business risk is the possibility of a credit customers failing to pay because of circumstances connected with the customer’s business activities and management.

I) Market Risk: Market risk is the exposure of the unit to the forward and backward linkage in the course of conducting its business, and the risk of facing sustained periods of unfavorable trends in such factors as product prices, raw material prices, single product dependence, pricing inflexibility, etc.

II) Operating Efficiency: In markets where competitiveness is largely determined by costs, the market position is determined by the unit’s operational efficiency. The result of these factors is reflected in the ability of the unit to maintain /improve its market share and command differential in pricing. In a competitive market, it is critical for any business unit to control its costs at all levels. This assumes greater importance in commodity or “me too” businesses, where low cost producers almost always have an edge. Cost of production to a large extent is influenced by location of the production unit(s), access to raw materials, access to human resources, scale of operations, technology, and level of integration, experience and the ability of the unit to efficiently use its resources.

C) Management Risk

Management risk refers to the instance of risk of nonpayment arising out of a business failure due to the perceived inefficacies of the management. The elements in management risk are assessing the management quality judged on the basis of the basic educational qualification, professional experience of the entrepreneur; and business attitude that is related to the motivation of carrying out the business and pursuing business strategies. In assessing management quality three factors are critical:

Character - relate to the willingness to pay. Apart from the characteristic disposition of honesty and integrity, several aspects are judge in terms of

1. Track record of previous borrowing and payment is an indicator. 2. Whether the owners/ directors have a financial interest in the business. 3. Business premises given the impression of a well-run unit.


Ability - relates basically to the ability to pay. Credit worthiness of the buttoner/borrowing company is assessed, including financial strength, and

Capacity - refers to the borrower having technical, managerial and financial abilities in order to operate profitably and succeed in business.

D) Financial Risk Financial risk analysis involves thorough evaluation of the financials of the SMEs. Careful analysis of the audited financials, observations of auditors in the auditor’s report and notes to accounts, consistent treatment of financials play an important role. Key ratio analysis, trend ratios, and financial disclosures and off Balance sheet items and their impact on the profitability is studied and analyzed in depth. Further the source of financial funding and their impact on the capital employed structure needs to be analyzed. Availability of liquid investments, unutilized lines of credit, financial strength of group companies, market reputation, relationship with financial institutions and banks, enterprise perceptions and experience of tapping funds from different sources also play an important role in financial analysis. Past performance of the company, level of financial transparency i.e. quality of documents and future plans plays an important role in the determination of rating.

Other parameters

Besides these 5 broad heads other parameters like applicability of pollution control certificate, impact of subsidies and sales tax deferral loans, impact of changes in accounting policies, unabsorbed depreciation and business loss, impact of non insurance or inadequate insurance of assets, extraordinary or windfall gains and losses, analysis of bank statements, violations of accounting standards if any, change in management, impact of the new monetary or fiscal policies or significant development in the industry are thoroughly assessed on case to case basis. Legal risks, foreign exchange fluctuation risk and hedging mechanism followed by the enterprise if any, is studied in detail.


4.4.1Small Medium Enterprises (SMEs) Rating Methodology PARTICULARS

CRISL ARGUS BDRAL

1. Industry Risk

Impact of subsidies/ taxation by the government, sudden business loss, impact of non insurance or inadequate insurance of assets, extraordinary gains and losses, legal or environmental embargo, impact of the new monetary or fiscal policies or significant development in the industry

2. Growth potential 3. Industry vulnerability 4. Barriers to entry / Exit 5. Threats of Substitute 6. Level of competition

In which an enterprise operates plays a crucial role in the credit risk assessment. It is a key determinant of the level and volatility in earnings

2. Business Risk

Market situation, estimated project cost, cost overrun, implementation plan, competence of the sponsor in implementing new project, estimated cash generation.

1. Market position 2. Business diversity 3. Operating efficiency 4. Cost structure

Possibility of credit customers failing to pay because of customer’s business activities and management. I) Market Risk II) Operating Efficiency

3. Management Risk

good control over the borrowers ; willingness to repay loan; ability to pay its obligations; handle the business efficiently; Working condition and relationship between the employer and employees

2. Track Record 3. Capacity to overcome

adversity 4. Risk appetite 5. Succession Plans 6. Goals, Philosophy and

strategies

The instance of risk of nonpayment arising out of a business failure due to the perceived inefficacies of the management.

i) Character ii) Ability iii) Capacity

4. Financial Risk

Financial position, working capital utilization and cash flow movement. net worth, asset size, liability, turnover, cost pattern, profitability, cash flow adequacy to debt repayment

Earnings; Capital structure and leverage; Interest coverage and liquidity levels; Cash flow analysis; Financial flexibility; Financial policy.

Involves thorough evaluation of the financials of the SMEs. Past performance of the company, level of financial transparency i.e. quality of documents and future plans plays an important role in the determination of rating.

Table 8: Small Medium Enterprises (SMEs) Rating Methodology


4.5 Rating Methodology (Insurance Company)

Insurer Financial Strength (IFS) rating of a General insurance company assesses the financial strength of an insurance company and its capacity to meet obligations to policyholders on a timely basis.

Methodology

NCR’s analyses incorporate an evaluation of the rated company’s current financial position as well as an assessment of how the financial position may change (to meet all of its obligations) in the future. NCR’s rating methodology focuses on the following five areas of analysis:

Industry Review Operational Review Organizational Review

Management Review Financial Review

Industry Review

The starting point for NCR’s ratings is a thorough understanding of the industry in which the insurer operates. One of NCR’s goals is to judge the extent industry dynamics can impact the ratings levels that individual insurers operating in a given industry segment can achieve. NCR’s specific evaluation of the general insurance industry focuses on:

i. Level of competition in specific sectors, and how variable competition has been over time.

ii. The basis for competitive advantage in the sector. iii. Barriers to entry and threats of new products iv. The potential “tail” of losses and ability to make accurate pricing decisions, as

well as exposure to large unexpected losses v. Regulatory, legal and accounting environment and framework.

Operational Review

NCR’s operational review focuses on a given company’s unique competitive strengths and weaknesses, operating strategies, and business mix. NCR’s analysis focuses on both the historical and current business position and how it is expected to change over time. NCR’s operational review includes an evaluation of:

Underwriting expertise and market knowledge

Distribution capabilities and mix Classes of business and changes in

mix Market share and growth

Brand name recognition and franchise value

Expense efficiencies and operational scale

Product and geographical mix Administrative and technological

capabilities


Organizational Review

NCR places importance on the influence of the owners on the company and the extent of financial support they would extend in case of any emergency. Moreover, NCR also assesses the credibility, market reputation and experience of the owners in the relevant field.

Management Review

One of the most difficult, yet critical aspects of NCR’s rating process is the level of confidence we develop in the management team and its stated strategies. NCR specific evaluation of management focuses on the following:

Strategic vision Appetite for risk Credibility and track

record for meeting expectations

Controls and risk management capabilities

Depth, breadth, and succession plans Accomplishments of key executives

Financial Review

NCR’s financial review includes the calculation of numerous financial ratios and other quantitative measurements. These are evaluated based on industry norms, specific rating benchmarks, prior time periods and expectations developed by NCR specific to the rated entity. In addition to the published financial statements NCR examines the management reports, evaluations and company projections. The financial review is broken into six main segments:

Underwriting quality Profitability Investments

Reinsurance utilization Reserves and Capital adequacy Liquidity

Underwriting Quality: :NCR’s goal is to judge the overall health of the book of business, and management understands of its risks and ability to control them. Key areas considered include:

Underwriting expertise in each class of business Pricing credibility Pricing flexibility given competitive and regulatory environment Exposure to large losses Balance of premium growth and underwriting discipline Controls over any third party underwriters, such as managing general agents Claims management and expertise Expense efficiencies, and impact of ceding commissions on expense ratios

NCR measures underwriting performance using two common ratios – the loss ratio and the expense ratio. To properly interpret these ratios, NCR considers the company’s business mix, pricing strategy, accounting practices, distribution approach and reserving approach. The combination of the loss and expense ratios is referred to as the combined ratio. A combined ratio below 100% translates into an underwriting profit, and above 100% represents an underwriting loss.


Profitability: The focus of NCR’s analysis of profitability is to understand the sources of profits, the level of profits on both and absolute and relative basis, and potential variability in profitability. Profits for general insurers are sourced from two primary functional areas –underwriting and investment income. Profits derived from investments can take the form of interest, dividends and capital gains and can vary as to their taxable nature. To further understand the quality of earnings, NCR evaluates the diversification of earnings, as earnings that are well diversified tend to be less volatile. NCR also calculates the following standard profitability ratios: return on assets (ROA) and return on equity (ROE).

Investments/Liquidity: NCR’s analysis of the investment portfolio focuses on credit risk, market risk, liquidity and historical performance. As part of NCR’s analysis, the company’s investment guidelines and management controls are also evaluated to understand how the investment portfolio may change over time. NCR examines credit risk by looking at the company’s exposure to higher risk investments relative to the total investment portfolio and capital base. NCR examines the company’s investment yield, total return, duration and maturity structure, and historical default experience. Volatility of investment valuations is considered in the context of both book value and underlying market (liquidation) values.

Reinsurance Utilization: In assessing an insurer’s use of reinsurance, NCR’s goal is to determine if capital is adequately protected from large loss exposures, and to judge if the ceding company’s overall operating risks have been reduced or heightened. In the traditional sense, reinsurance is used as a defensive tool to lay off risks that the ceding company does not want to expose to its earnings or capital. When reinsurance is used defensively, NCR’s goal is to gain comfort that:

Sufficient amounts and types of reinsurance are being purchased to limit net loss exposures given the unique characteristics of the book

Reinsurance is available when needed The cost of purchasing reinsurance does not excessively drive down the ceding

company’s profitability to inadequate levels, and weaken its competitive pricing posture

The financial strength of reinsurers is strong, limiting the risk of uncollectible balances due to insolvency of the reinsurer.

Exposure to possible collection disputes with troubled or healthy reinsurers is not excessive

Reserves and Capital Adequacy: Reserve adequacy is a critical part of the financial review, and a demonstrated ability to maintain an adequate reserve position is a crucial characteristic for a highly rated insurer. While the analysis of reserve adequacy includes a robust quantitative element, much of NCR’s reserve review is qualitative in nature. Accordingly, our review focuses on the following:

Historical track record in establishing adequate reserves Management’s reserving targets Key reserving assumptions General market and competitive pricing environment, and propensity of management

to carry weaker reserves during down cycles Use of discounting, financial reinsurance or accounting techniques that reduce carried

reserves Comparison of company loss development trends relative to industry and peers


Liquidity: In short-tail insurance sectors, liquidity is particularly important. NCR justify liquidity based on the marketability of investments. The manner in which the company values its assets on the balance sheet is also closely examined.

NCR evaluates trends in operating and underwriting cash flows to judge liquidity at the operating company level. NCR also considers cash flows in the context of future levels of investment income generated by a shrinking or growing portfolio. Off balance sheet sources of liquidity, including committed and uncommitted lines of credit, asset securitization and other funding arrangements, are also considered.

4.5.1 Diagram of CRABs General Insurance Rating Methodology

Figure 6: CRABs General Insurance Rating Methodology

Earnings Strength & Stability

Liquidity & ALM

Capital Adequacy

Asset Quality

Management & Corporate Strategy


Risk Underwritten

Business Profile

General Insurance

Input Output

Reserve Adequacy Solvency Margin

“Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation” – A Review on Bangladesh Context;| 49

4.5.2General Insurance Rating Methodologies PARTICULARS CRISL CRAB NCRL ECRL Industry Review Regulatory Compliance; Level

of competition; competitive advantage;

Competitive position; Capital Adequacy; Market Share; Distribution; Product Diversification; Asset Quality

Level of competition; competitive advantage; Barriers to entry and threats of new products; Regulatory, legal and accounting environment.

Pricing environment and phase in insurance cycle; trends in gross and net premiums; growth rates; distribution profile; regulatory changes; effect of the macroeconomic environment; new entrants and capital adequacy trends.

Operational Review

Ownership Pattern; Parent Support; The Board of Directors; Financial Reporting System; Marketing Strategy

Relationship between the BoD, Management and Shareholders; Degree of relationship to balance effectively shareholders and creditors interest; Board Effectiveness; Board Independence; Management Compensation; Key Personnel Risk; Insider and Related Party Risk; Integrity of Accounting and Audit

Underwriting expertise and market knowledge; Distribution capabilities and mix; Classes of business and changes in mix; Market share and growth; Brand name recognition and franchise value; Expense efficiencies and operational scale; Product and geographical mix; Administrative and technological capabilities

Business growth; Stability in Operating Performance; Underwriting and Investing.

Organizational Review

Market Position; Re-insurance; Quality of Investment Portfolio

Ownership and Organizational Complexity

Credibility, market reputation and experience of the owners.

Market position; competitive advantage; Business mix; Underwriting standards and claims management.

Management Review

Market Risk; Operational Risk; Event Risk; Management Information System; Human Resources Management

Underwriting Risks; Risk Governance; Risk analysis and Quantification; Risk Infrastructures and Intelligence; Credit Risk; Market Risk; Sovereign Risk; Management Evaluation(financial, operational, strategic)

Strategic vision; Appetite for risk; Credibility and track record for meeting expectations; Controls and risk management capabilities; Depth, breadth, and succession plans; Accomplishments of key executives

Increasing efficiency and productivity, enhancing technical skills in areas such as underwriting, information Systems and asset management, product innovation, and improving service quality.


Financial Review Financial Performance – Profitability; Operating Performance- Efficiency; Capitalization; Liquidity and Funding.

Earnings Strength and Stability (Return on Assets, Sharp Ratio of growth net income, Pretax return in Revenue); Reserve Adequacy; solvency Margin; Liquidity Assets and Liability Management

Underwriting quality; Profitability; Investments; Reinsurance utilization; Reserves and Capital adequacy; Liquidity.

Liquidity; Reserves; Investments; Capitalization; Reinsurance Utilization;

Table 9: General Insurance Rating Methodologies


4.6WCRCL Rating Scales & Definitions

LONG-TERM & SHORT-TERM RATINGS OF CORPORATE Lo

ng T

erm

Rat

ing

Cat

egor

ies

Investment Grade

AAA Issuer/Issue rated AAA is judged to be of the highest quality with minimal credit risk.

AA1, AA2, AA3

Issuer/Issue rated AA is judged to be of very high quality and subject to very low credit risk.

A1, A2, A3 Issuer/Issue rated A is an upper medium grade and subject to low credit risk.

BBB1, BBB2, BBB3

Issuer/Issue rated BBB is subject to medium credit risk. And considered medium grade and as such may possess certain speculative characteristics.

Speculative Grade

BB1, BB2, BB3

Issuer/Issue rated BB is judged to have speculative elements and subject to substantial credit risk.

B1, B2, B3 Issuer/Issue rated B is considered speculative and subject to high credit risk.

Risky Grade

CCC1, CCC2, CCC3

Issuer/Issue rated CCC is judged to be of poor standing and subject to very high credit risk.

CC1, CC2, CC3

Issuer/Issue rated CC is highly speculative and likely or very near in default, with some prospect of recovery of principal and interest.

C Issuer/Issue rated C is the lowest rated class of bonds and typically in default with little prospect of recovery of principal and interest.

Default Grade

D Indicates that the issuer/Issue is in default, is technically or actually in bankruptcy.


Shor

t Ter

m R

atin

g C

ateg

orie

s P1

Issuer/Issue rated “Prime – 1” has a superior ability to repay short term debt obligations. It is most likely to have the capacity to meet their obligations over the coming 12 months through internal resources without relying on external sources of committed financing.

P2

Issuer/Issue rated “Prime – 2” has a strong ability to repay short term debt obligations. It is likely to meet their obligations over the coming 12 months through internal resources but may rely on external sources of committed financing.

P3

Issuer/Issue rated “Prime – 3” has an acceptable ability to repay short term debt obligations. It is expected to rely on external sources of committed financing. Based on its evaluation of near term covenant compliance, WCRCL believes that the issuer may require covenant relief in order to maintain orderly access to funding lines.

P4

A short-term obligation rated 'Prime- 4' is regarded as having some speculative characteristics. The obligor currently has the capacity to meet its financial commitment on the obligation; however, it may face major ongoing uncertainties which could lead to the obligor's inadequate capacity to meet its financial commitment on the obligation.

P5

A short-term obligation rated 'Prime- 5’ is currently vulnerable to nonpayment and is dependent upon favorable business, financial, and economic conditions for the obligor to meet its financial commitment on the obligation.

P6 A short-term obligation rated 'Prime- 6’ is in payment default or jeopardized through bankruptcy petition of similar action.

Table 10: WCRCL Rating Scales & Definitions

“Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation” – A Review on Bangladesh Context;| E

Chapter # 05 Growth and Impact of Rating after Basel II

Implementation

5.1 Rating by CRISL & CRAB in 2008-2012 5.2 The Growth Rate of credit rating in 2009-2012 5.3 Total number of Rating in 2012 by Credit Rating Agencies 5.4 Total number of Rating in 2012 by Credit Rating Agencies (Grading Wise)


1. Impact of Rating after Basel II Implementation 5.1 Total Credit Rating Scenario in Bangladesh from 2008-2012

Graph 1: Total Credit Rating Scenario from in Bangladesh 2009-2012

The above Graph-1, make clear the increasing scenario of credit rating in Bangladesh. After introduction of Basel II it is increasing year to year at high rate. At 2008 it was only 88 where 2012 it is 2860. The total numbers of rating in 2011 to 2012 increase two times 1486.

5.2 The Growth Rate of credit rating in 2009-2012

Graph 2: Growth Rate of credit rating from 2009-2012

From above Graph-2, it is indicates that the number of rating is growing at a significant rate in every year. It’s also point out that the growth rate is decreasing 2010-2012. In 2010; the growth rate is high at 362.28%. Again growth rate decrease comparative to 2010. The growth rate of credit rating in Bangladesh at 2011 and 2012 is 175.90% and 08.15% respectively.

0.00%

100.00%

200.00%

300.00%

400.00%

20092010

20112012

29.55%

336.84%

193.37%

95.76%

2009 2010 2011 2012

88

114

498

1461

2860

0 500 1000 1500 2000 2500 3000 3500

2008

2009

2010

2011

2012

Total

2008

2009

2010

2011

2012


5.3 Total number of Rating in 2012 by Credit Rating Agencies

Graph 3: Rating in 2012 by Credit Rating Agencies

The Graph-3 is viewing the market capturing area by ECAI’s. Here, CRISL & CRAB are the leading (923 & 832 respectively) and oldest credit rating agencies in Bangladesh. And WCRCL, Alpha and BDRAL are newly launched, where BDRAL till not approved by Bangladesh Bank as ECAI’s.

5.4 Rating by CRISL & CRAB in 2008-2012

Graph 4: Rating by CRISL & CRAB in 2008-2012

The Graph-4 is denoting the number of rating 2008-2012 by CRISL & CRAB. These two are capturing the momentous area of rating market in Bangladesh. Where, CRISL is the first and largest credit rating companies in Bangladesh and CRAB is the second.

CRISL CRAB NCRL ECRL ARGUS WCRCL Alpha BDRAL

Rating, 2012 923 832 556 404 96 17 17 15

0

200

400

600

800

1000

Num

ber

Rating, 2012

40 70

300

600

923

48 44

198

660

832

2008 2009 2010 2011 2012

CRISL & CRAB in 2008-2012CRISL CRAB


5.4 Total number of Rating in 2012 by Credit Rating Agencies (Grading Wise)

Graph 5: Rating in 2012 by Credit Rating Agencies (Grading Wise)

Graph-5, highlighting the long term scale wise rating by eight credit rating agencies in 2012. Where, Issuer/Issue rated AAA is judged to be of the highest quality with minimal credit risk is lower (10). And Issuer/Issue rated BBB is subject to medium credit risk (considered medium grade and as such may possess certain speculative characteristics) is at high 1113.

AAA, 10

AA, 278 A, 339

BBB, 1113

BB, 821

B, 247

0

200

400

600

800

1000

1200

AAA AA A BBB BB B

“Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation” – A Review on Bangladesh Context;| F

Chapter # 06 Banks Performance Pre &

Post of Basel II Implementation

6.1 Bank Performance (pre and post of Basel II) 6.2 Importance of Credit Rating in the Banking Sector 6.3 Impact of Basel II on banking industry


6.1 Bank Performance (pre and post of Basel II)

Profitability is one of the indicators to measure the improvement in the banking industry. We analyze two profitability ratios, namely "Return on Assets (ROA)" and "Return on Equity (ROE)", and the "Net Interest Margin (NIM)” for the banking sector since 2005. All these variables have increased considerably during the period.

2005 2006 2007 2008 2009 2010 2011

ROA 0.6 0.8 0.9 1.2 1.37 1.8 1.95

ROE 12.4 14.1 13.8 15.6 21.72 15.5 19.27

NIM 35.3 44.3 54.8 70.9 81.46 121.9 142.32

Table 11: Aggregate Profitability of the Banking Industry in Bd. (Source: Statistics Department, Bangladesh Bank)

ROA: A basic measure of bank profitability that corrects for the size of the bank is the return on assets (ROA), which divides the net income of the bank by the amount of its assets. ROA is a useful measure of how well a bank manager is doing on the job because it indicates how well a bank’s assets are being used to generate profits.

RoA=ே௧ ூே௧ ௦௦௧௦

Graph 6: Aggregate Return on Asset of Banking Industry in Bangladesh (Source: Statistics Department, Bangladesh Bank)

The graph 6 is showing the increasing scenario of return on assets pre and post of Basel II in 2006 it was only 0.6 and in 2011 it was about 2(1.95).

ROE: Although ROA provides useful information about bank profitability, but it is not what the bank’s owners (equity holders) care about most. They are more concerned about how much the bank is earning on their equity investment, an amount that is measured by the return on equity (ROE), the net income per dollar of equity capital. RoE=ே௧ ூ

௧

2005 2006 2007 2008 2009 2010 2011

ROA 0.6 0.8 0.9 1.2 1.37 1.8 1.95

0

0.5

1

1.5

2

2.5

ROA

Return on Assets


Graph 7: Aggregate Return on Equity of Banking Industry in Bangladesh (Source: Statistics Department, Bangladesh Bank)

The above graph 7 is indicating the pre and post (Basel II) scenario of return on equity of banking industry. Where, immediate year (2009) after Basel II introduction ROE reach on the peak (21.72). NIM: Another commonly watched measure of bank performance is called the Net Interest Margin (NIM), the difference between interest income and interest expenses as a percentage of total assets: NIM=ூ௧௦௧ ூିூ௧௦௧ ா௫௦௦

ே௧ ௦௦௧௦

Graph 8: Aggregate Return on Asset of Banking Industry in Bangladesh(Source: Statistics Department, Bangladesh Bank)

The graph 8 is showing the increasing scenario of net interest margin of the banking industry in Bangladesh. In 2005 it was only 35.3 but after Basel II implementation it increase at high rate that’s why, in 2011 it was 142.32.

0

5

10

15

20

25

2005 2006 2007 2008 2009 2010 2011ROE 12.4 14.1 13.8 15.6 21.72 15.5 19.27

ROE

Return on Equity

0

50

100

150

2005 2006 2007 2008 2009 2010 2011NIM 35.3 44.3 54.8 70.9 81.46 121.9 142.3

Axi

s Ti

tle

Net Interest Margin


6.2 Importance of Credit Rating in the Banking Sector

In this study I have found the following importance of credit rating in the Banking Sector:

To increase investor confidence and guide time to time. Facilitate decision making at the time of taking loan or making investment. Credit rating measures probability of default to meet obligations. Credit rating states the strengths and weaknesses of the company by which company

take chance to use strengths and remove its weaknesses. Rated instrument enjoys higher confidence to the clients of the company that they are

less risky. Provide information and guidance to institutional and individual investors/creditors. Enhance the ability of borrowers/issuers to access the money market and the capital

market for tapping a larger volume of resources from a wider range of the investing public.

Assist the regulators in promoting transparency in the financial markets. Provide intermediaries with a tool to improve efficiency in the funds raising process.

6.3 Impact of Basel II on banking industry

After all I found that Basel II affects the banking industry by the following ways:

• Risk management:

The process of identification, analysis and either acceptance or mitigation of uncertainty in investment decision-making. Essentially, risk management occurs anytime an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment and then takes the appropriate action (or inaction) given their investment objectives and risk tolerance. Inadequate risk management can result in severe consequences for companies as well as individuals. For example, the recession that began in 2008 was largely caused by the loose credit risk management of financial firms. Basel II gives emphasis on credit risk assessment of banks.

Risk management is the continuing process to identify, analyze, evaluate, and treat loss exposures and monitor risk control and financial resources to mitigate the adverse effects of loss.

Loss may result from the following: Financial risks: such as cost of claims and liability judgments Operational risks: such as labor strikes Perimeter risks: including weather or political change Strategic risks: including management changes or loss of reputation Expectations on the Board

Expectations on the board are vital point of modern business. Every stake holder has some expectations on the board e.g. to treat each other with dignity and respect, to maintain the confidentiality of information that is designated as confidential and discussed and/or


disclosed during the meetings etc. By making assessment basel ii express the degree of expectations meeting by board.

• Human capital

A measure of the economic value of an employee's skill set. This measure builds on the basic production input of labor measure where all labor is thought to be equal. The concept of human capital recognizes that not all labor is equal and that the quality of employees can be improved by investing in them. The education, experience and abilities of an employee have an economic value for employers and for the economy as a whole. By assessing human capital basel ii express the quality of human capital and give chance to make improve.

• Industry structure (mergers?) & competitiveness

Basel II also state the insight view of the industry and how much competitive to the market. If anyone desire to merge or compete with the entity they should look first their rating or weight, how much risky it.

• Capital impact

The major impact of basel ii on capital. If the rating is good or high they can raise capital easily and low cost, otherwise vice-versa. On another side, if rating is good then the banking industry make investment in productive sector of their additional capital.

“Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation” – A Review on Bangladesh Context;| G

Chapter # 07 Conclusion

7.1 Prospects of Credit Rating in Bangladesh 7.2 Findings of the Study 7.3 Recommendation of the Study 7.4Conclusion 7.3 References 7.4 Appendixes

“Role of Credit Rating in the Banking Sector after Introduction of Basel II Regulation” – A Review on Bangladesh Context; Page | 60

7.1 Prospects of Credit Rating in Bangladesh

1. Bangladesh Bank is going to publish soon a rule that rating is mandatory for all clients who will take loan one core or more than one core from bank.

2. Basis for proactive risk management alongside the development of the customer creditworthiness;

3. Greater protection to depositors due to development of a better risk management culture and systems for banks;

4. Improved risk management will enhance the banking sector’s ability to offer to customers more sophisticated products such as derivatives;

5. Greater sensitivity to customer risk due to changes in measuring risks, which will allow for better risk-adjusted pricing, with lower rates for better customers;

6. While enhanced risk assessment might affect loan pricing, capital is just one of the factors for credit margin (e.g. competition, cost and efficiency of individual bank and desired minimum margin on assets);

7. Enhanced disclosure of information – published CAR (Capital Adequacy Ratio) will reflect more accurately change in risk profile; improvement of shareholder value and public confidence.

7.2 Findings of the Study

The credit rating market in Bangladesh is going to vast competitive day by day after

introduction of Basel II (at present there are seven BB approved CRA’s & One under

process in Bangladesh).

With the awareness of credit rating (Basel II) among the individual or corporation the

number of rating is increasing day by day (Chart-2).

Medium grade (BBB) achieved companies are the highest number in Bangladesh (841

in 2012, Chart-4).

CRISL and CRAB are the leading Credit Rating Agencies (CRA’s) in Bangladesh

(Chart-3).

Bangladesh Bank is going to publish soon a rule that rating is mandatory for all

clients who will take loan one core or more than one core from bank.

The incorporation of credit ratings into the regulatory regime has occurred under the

first pillar of the Basel II Accord, which allows banks to use credit ratings to

determine risk weights in the standardized approach to capital adequacy.

Beside vast advantages it has some disadvantages (biasness, absence of quality rating,

concealment of material information).


For high competition among the credit rating agencies clients desire high rate, which

agency will provide high rate, they take rating from them.

CRAs greed, ignorance and incompetency undoubtedly had a key role in opening the

gates of the financial world to the poison chalice of structured instruments.

The central reason for CRAs failure is CRAs revenue maximum comes from the very

companies they rate, created conflicts of interest which inhibited the CRAs from

successful gate keeping.

If company owns poor grade or absence of quality rating, it would face a critical time,

where they do not take loan or make investment easily that’s why company try to hide

the rating information.

If a company fall in down temporarily it will negatively reflects the company rating

and impact after rating.

Rating grade provided by the agencies vary from one to one. Because the

measurement techniques are not similar.

Certifying qualitative factors (management, ownership, accounting quality, franchise

value etc.) is not possible accurately.

Future is always uncertain it is only possible to guess. As credit rating based on the

past and present performances future can change at any time.

Information gap also can produce unqualified (reverse) grade that’s why company can

downfall at any time (Enron).

With the growing awareness of credit rating after introduction of Basel II, all clients

are trying to increase the overall quality that’s why the quality of rating is going up

year to year.

7.3 Recommendations

Bank and Fund technical assistance to countries should focus on strengthening financial sector infrastructure, core supervisory functions in line with the BCP and including risk-based supervision, as well as conditions allowing for the exercise of market discipline. These are essential prerequisites for countries seeking to adopt the Basel II framework. Bank and Fund staff should avoid conveying the perception that countries will be criticized by the Bank or Fund for not moving to adopt the Basel II framework.

Bank and Fund staff will provide assistance to host countries wishing to strengthen their supervision but should, at the same time, take a neutral position with regard to the question of whether host supervisors should permit foreign banks in their countries to operate under Basel II (particularly the advanced approaches), while


domestic banks remain under Basel I. Host supervisors, however, should retain responsibility for the supervision of all banks operating under their jurisdiction.

Internally, the Bank and the Fund would need to allocate resources to continue to upgrade staff knowledge of all aspects of Basel II, including the more advanced elements of Pillar I, through segment to supervisory agencies, through internal and external training of existing staff and through hiring staff familiar with Basel II. Although availability of resources in the area of Basel II will be scarce for the coming years, the Fund and the Bank will need to position themselves, within the existing resource envelope and using external funding where possible, to recruit outside short-term and long-term experts to assist in building the IFIs' own expertise and to participate in technical assistance activities.

Bangladesh Bank (BB) should ensure the quality of credit rating agencies.

Bangladesh Bank (BB) should directly control the Credit Rating Agencies (CRA’s).

All Credit Rating Agencies (CRA’s) should free from biasness, personal relation,

personal benefits etc.

Growing awareness among the clients about credit rating and Basel II. Make mandatory rules ensure rating for every client who takes one core or more loans from the banks.

Bangladesh bank should strictly control the propensity of getting higher grade than actual have.

CRAs need to broadly adjust their methodologies and procedures. At the same time, a critical review of CRA regulation is required.

7.4 Conclusion

Credit Rating is an assessment of ability to pay current obligation of an individual or corporation on the basis of borrowing and repayment capacity by which anyone can take decision where should make investment or from where should take loan devoid of any risk. Without any doubt, the role of credit rating in the banking sector after introduction of Basel II regulation is at remarkable position (growing in every year, Chart 2). It will promote adoption of stronger risk management practices, which will help enhance the safety and stability of the local banking sector. As a growing economics which prides itself on adopting the latest best practices, it is going to natural for Bangladesh to implement Basel II at the same time as the Basel Committee members. Introduction of Basel II will enhance the reputation and international standing of Bangladesh and our banks. Clients timely feedback on the draft Rules will help Bangladesh Bank to meet the target implementation timetable.

On the whole analyses I have able to take decision that the credit rating playing a great role in minimizing credit risk by creating corporate image, market expansion, growth expediting, cost minimizing, etc.. Though it has some negative impact on the related parties, the significant reason for negative impact is undoubtedly the exponential growth of the structured finance market (high volume of competition). To avoid that problem Bangladesh Bank


should directly/straightly control and make ensure the good practices of law and providing CRAs incentives to the goal of high quality credit ratings.

In summary, Basel II aims not only to align regulatory capital more closely with risk but to promote a more sophisticated approach to risk management and to create a 'risk culture' inside lenders, whereby the organization, and senior management in particular, understand risk and remain alert to risk as a core issue. Now that lenders have moved to Basel II, they have discovered just how substantial a change it is, although for the time being they are also still being required to conform to the Basel I capital floors as well, so are unlikely to have seen a significant reduction in their regulatory capital requirement.

The recent global financial crisis has revealed weaknesses in the whole approach to risk management that has been developed through the Basel II process. Management has been expected to be vigilant about risk but risks have come from unexpected places. Assumptions about the liquidity of financial instruments such as mortgage backed securities (MBS) that were based on past performance have proven unfounded as has the reliability of credit ratings on many of these MBS.

7.5 References

Akhtar, Shamshad, Governor of the SBP, 2006, “Basel II Implementation: Issues, Challenges and Implications”, 56th Annual General Meeting – Institute of Bankers Pakistan

Altman, EdwardI. and Herbert A. Rijken, 2004, "How Rating Agencies Achieve Rating Stability," Journal of Banking and Finance 28(November), pp.2679-2714.

Berger, Allen, Sally Davies and Mark Fl annery, 2000," Comparing market and supervisory assessments of bank performance- who knows what when", Journal of Money credit and Banking 32(3)(August),641-667.

Bils, Mark, PeterJ.K lenow and Benjamin A. Malin, 2009, "Reset Price Ináation and the Impact of Monetary Shocks, "NBER Working Paper 14787,March.

BRPD circular available at: www.bb.org.bd BRPD Circular no. 14/2007 dated December 30, 2007 BRPD Circular no. 7/2008 dated September 23, 2008 BRPD Circular no. 9/2008 dated December 31, 2008 BRPD Circular no. 16/2008 dated December 31, 2008 BRPD Circular no. 20/2009 dated December 29, 2009

Cantor, Richard, 2004,"An Introduction to Recent Research on Credit Ratings,"Journal of Banking and Finance 28(November), pp.2565-2573.

Carey, Mark and Mark Hrycay,2001."Para meterizing Credit Risk Models with Rating Data," Journal of Banking and Finance 25,197-201.


Chen,Qi and Wei Jiang, 2006,"Analystsí Weighting of Publicand Private Infomration," Review of Financial Studies 19,319-355.

Fakhar, Fozia, 2005, “Basel II: A Step Forward in Risk Management”, Journal of IBP, April-

June, pp 15-19.

Jacobson,Tor, Jesper Lind È,and Kasper Roszbach,2006,"InternalRatings Systems, Implied Credit Risk and the Consistency of Banks í Risk Classi Öcation Policies," Journal of Banking and Finance 30,1899-1926

Rahman , Muhammad Mustafizur Banking Sector Reforms in Bangladesh and its Impact (2012), thesis paper, Masters of Business Administration, The University of Dhaka, Dhaka, Bangladesh

Roadmap for the implementation of Basel II in Bangladesh, BB.

Sheng, A. (1996). Bank Restructuring: Lesson from the 1980s. Washington: The World Bank.

Supervisory guidance on cross-border cooperation is provided in "High-Level Principles for the Cross-Border Implementation of the New Accord," Basel Committee on Banking Supervision (August 2003).

Treacy, Williamand Mark Carey,2000,"Credit Risk Rating Systemsa Large U.S.Banks",

Journal of Banking and Finance 24,pp.167-201.


Appendixes

Appendix 1: Methodology requires minimum information on following parameters

A. Corporate (other than Bank and Non-bank Financial Institution)

i) Financial Risk iv) Security Risk Leverage Experience Liquidity Succession Profitability Team Work Coverage ratio iv) Security Risk ii) Business/Industry Risk Security Coverage Size of Business Collateral coverage Age of Business Support/Guarantee Business Outlook legal intervention (If any) Industry Growth v) Relationship Risk Competition Account Conduct Entry/Exit Barriers to Business Utilization of Limit –If any loan from bank iii) Management Risk Compliance of covenants/conditions with

banks & other counterparty Experience Deposit with bank or others Succession Team Work B. Bank and Non-bank Financial Institution

i) Quantitative Factors Capital Adequacy Asset Quality Earning quality Liquidity and Capacity of External Fund

Mobilization Size of the Bank and Market Presence ii) Qualitative Factors Management Regulatory Environment & Compliance Risk Management Sensitivity to Market Risk Ownership (Share holding pattern) and

Corporate Governance Accounting Quality Franchise Value C. Quantitative and Qualitative risk factors for other business segments i.e. Securitization exposure, Insurance Company, Autonomous Bodies etc. have to be enclosed.



Appendix 2: The mapping of rating scales of EACI’s

Long Term Rating Category Mapping BB’s Rating Grade

Equivalent Notch/Notation of CRISL

Equivalent Notch/Notation of CRAB

Equivalent Notch/Notation of NCRL

Equivalent Notch/Notation of ECRL

Equivalent Notch/Notation of ARGUS

1

AAA AAA AAA AAA AAA AA+, AA, AA AA1, AA2,

AA3 AA+, AA, AA AA+, AA, AA AA+, AA, AA

2 A+, A, A A1, A2, A3 A+, A, A A+, A, A A+, A, A 3 BBB+, BBB,

BBB BBB1, BBB2, BBB3

BBB+, BBB, BBB

BBB+, BBB, BBB

BBB+, BBB, BBB

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

BB+,BB, BB BB+,BB, BB BB+,BB, BB

5 B+, B, B- CCC+, CCC, CCC- CC+, CC, CC-

B1, B2, B3 CCC1, CCC2, CCC3 CC

B+, B, B- B+, B, B- B+, B, B-

6 C+, C, C-, D C, D C+, C, C-, D C, D C+, C, C-, D Short Term Rating Category Mapping

S1 ST-1 ST-1 N1 ECRL-41 ST-1 S2 ST-2 ST-2 N2 ECRL-2 ST-2 S3 ST-3 ST-3 N3 ECRL-3 ST-3 S4 ST-4 ST-4 N4 ECRL-4 ST-4 S5, S6 ST-5, ST-6 ST-5, ST-6 N5 D ST-5, ST-6



Appendix 3: Rating Scenario in Bangladesh

Year CRISL CRAB NCRL ECRL ARGUS WCRCL ALPHA BDRAL Total Growth Rate*

2008 40 48 0 0 0 0 0 0 88 2009 70 44 0 0 0 0 0 0 114 29.55% 2010 300 198 0 0 0 0 0 0 498 336.84% 2011 600 660 114 87 0 0 0 0 1461 193.37% 2012 923 832 556 404 96 17 17 15 2860 95.76%

*Growth Rate= ି

×

Appendix 4: Rating Matrix

GRADE CRISL CRAB NCRL ECRL ARGUS WCRCL ALPHA BDRAL Total AAA 4 3 0 3 0 0 0 0 10 AA 112 88 57 15 3 1 1 1 278 A 109 49 77 41 59 2 1 1 339 BBB 241 302 248 273 33 3 5 8 1113 BB 364 305 95 42 1 7 5 2 821 B 79 68 65 23 0 4 5 3 247 CCC 0 0 0 0 0 0 0 0 0 CC 0 0 0 0 0 0 0 0 0 C 0 0 0 0 0 0 0 0 0 D 0 0 0 0 0 0 0 0 0


Appendix 5: Aggregate Profitability of the Banking Industry in Bangladesh

2005 2006 2007 2008 2009 2010 2011

ROA 0.6 0.8 0.9 1.2 1.37 1.8 1.95

ROE 12.4 14.1 13.8 15.6 21.72 15.5 19.27

NIM 35.3 44.3 54.8 70.9 81.46 121.9 142.32

Source: Statistics Department, Bangladesh Bank

Education

Role of credit rating in the banking sector after introduction of basel ii regulation