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CAPITAL ADEQUACY AND CREDIT RATING:

PRELIMINARY EVIDENCE FROM INDIAN PUBLIC SECTOR BANKS


D.M.Nachane and Saibal Ghosh*
(Department of Economics, University of Mumbai, Justice M.G.Ranade Bhavan,
“Vidyanagari”, Vidyanagari Marg, Mumbai – 400 098).
I. Introduction
The Capital Adequacy Framework of the Basle Committee on Banking Supervision
(BCBS) (1988) is widely regarded as the single most successful attempt in the move
towards convergence of international standards in banking, enabling cross-country
assessments and comparisons of internationally active banks. The results of a 1996
survey conducted by the BCBS indicated that 92 percent of the 140 participating
countries had put in place a risk-weighted framework along the lines of the Basle
approach (Musch, 1997). Despite being acknowledged as a valuable framework for
comparing risks associated with assets, the approach has been the subject of some
criticism. Under the framework, all corporate borrowers in the non-financial sector were
risk weighted uniformly at 100 percent, despite wide divergences in the associated risks
and all bank loans were risk-weighted at a uniform 20 percent, despite there being wide
variation in the financial strengths of different banks. Again, the framework placed a more
favourable risk weight on a weak bank than on a very strong non-banking company. This
lack of risk differentiation has been cited as an important incentive for banks to enter into
transactions, specifically with a view to arbitrage such anomalies and to shift to lower
quality and higher risk assets in the same asset category.
II. The New Capital Accord
In order to address such anomalies, the BCBS proposed a revised Capital Adequacy
Framework in 1999 (BIS, 1999) which uses a three pillar approach - (i) a standardised
approach based on External Credit Assessments (ECA) and / or Internal Ratings Based
(IRB) approach, which seeks to align more finely the risk weights with actual credit risks
(ii) a supervisory review pillar to ensure that the bank's capital is aligned to its actual risk
profile and (iii) a market discipline pillar to enhance the role of the other market
participants in ensuring that appropriate capital is held by banks though higher disclosure
requirements. The revised Accord is being widely discussed and debated and is expected
to be operational by the year 2005. While the approach itself is certainly being viewed as
an improvement over the simple standardised approach followed at present, it poses
practical difficulties in implementation for both the banks and their supervisors in
emerging economies, which may be deficient in the sophistication and the skills required
for implementing such an approach as well as the background data, which is an essential
prerequisite. There is no conclusive evidence as to whether the benefits of more
efficiently allocating capital to risk will outweigh the costs of implementing the new
Accord-either for the banks or for the supervisors in these economies. Further, the
sophistication of the new Accord could well divert resources from supervision to capital
regulation and monitoring, leading supervisors into a false sense of security that capital
adequacy is an all-encompassing indicator of financial soundness, to the exclusion of
other perhaps more relevant indicators.

*
The views expressed in the paper are entirely personal and do not, in any way, reflect those of the
institution to which the authors belong.
32 THE INDIAN ECONOMIC JOURNAL

III. Received Literature


The literature on whether capital ratios impact credit ratings is still in a state of infancy.
The early studies with respect to US banks notably by Peltzman (1970), Mingo (1975)
and Dietrich & James (1983) all examine whether either book or market capital in the
1960s and 1970s reflects regulatory influence. Most of these studies are generally in
agreement about regulators' inability to influence changes in capital1. Thereafter, Keeley
(1988) concluded favourably on the hypothesis that the December 1981 regulatory
regime shift (U.S.) increased regulatory control of capital ratios. It is of note that none of
these studies used the concept of credit rating in their analysis. Recently, Swindle (1995)
attempted to separate the relative roles of the market and regulators using the CAMEL
(Capital Adequacy, Asset Quality, Management, Earnings and Liquidity) rating of
supervisors. His analysis suggests that banks with lower regulatory capital ratings have
higher expected increases in their primary capital ratios and to that extent, represents an
important advance on earlier studies in attempting to explicitly incorporate (supervisory)
ratings in understanding the response of capital-sufficient (deficient) banks to regulatory
pressure. However, supervisory ratings are not information in the public domain, and
therefore, it is difficult to evaluate, a priori, the extent to which regulatory pressure
(proxied by CAMEL) was significant in influencing bank capital ratios. Most of the studies
referred to above employ some proxy for measuring regulatory pressure. In a significant
departure, Kamin and von Kleist (1999) employed a linear mapping of ratings to risk with
Aaa (of Moody’s) and AAA (of Standard and Poor’s) being assigned a value of 1, and the
lowest value being 16 for B3 (of Moody’s) and B- (of Standard and Poor’s). Their analysis
reveals that in cases where ratings are assigned by both Moody’s and Standard and
Poor’s, they were identical for 58 per cent of the issues and differed by one notch for 36
per cent of the issues. Subsequently, Monfort and Mulder (2000) employed a dynamic
error-correction model to discern the relationship between (sovereign) ratings and several
indicators of crisis in 20 emerging market economies. Their analysis suggests modest
efficiency gains by using sovereign credit ratings for capital requirements in lending to
emerging markets.
IV. New Capital Accord and Ratings
The revised Accord places an explicit emphasis on rating. Risk differentiation between
counter parties, be they sovereigns, banks, corporates, public sector enterprises or
securities firms, will be either on the basis of external or internal ratings. Risk dispersion
is sought to be achieved by ranging the possible risk weights from 20 per cent to 150 per
cent, depending upon the rating of the counter-party, instead of the flat-rate 20 per cent
(for banks) or an uniform 100 per cent (for others), as at present. The rating is to be either
by an external rating agency or by the bank's own internal rating process. However, the
reliance on external ratings agencies presents a problem, given the low penetration of
these agencies in most developing economies. Leaving aside the issue of penetration,
the fact remains that banks in most emerging markets have already invested substantial
resources in the credit management function, and are thus relatively better placed than
external rating agencies to evaluate proposals. Abrogating this function to the rating
agencies might not yield the desired results. In India, even the vast majority of corporate
borrowers are un-rated. Since such borrowers are given the benefit of a risk weight of 100
per cent, which is lower than that proposed for the lowest rated borrowers, there is no real
incentive to seek ratings for this vast majority. For the lending banks, this would mean a
status quo in risk weight at 100 per cent. However, such an incentive exists for those
borrowers who could get a premium rating, as this would make claims on them entitled to
Volume 49, No.1 33

a preferential risk weight of 20 per cent and correspondingly, provide them the leverage
to negotiate a finer rate from the banks. The lender banks similarly would be able to
discharge capital held against such loans at levels comparable to the present. An
additional capital requirement could however arise for Indian banks (under the revised
system) from the high NPA levels, for the un-provided portion of these assets could entail
a risk weight of 150 per cent associated with the lowest quality credits, raising the Basle
minima by an estimated 4 per cent on the capital to be allocated (Table 1). As far as
claims on other banks go, two options have been under consideration, of which the first
links the bank's rating to that of the sovereign in which it is incorporated. The option is
unlikely to find favor, since location cannot be a true indicator of financial strength, a case
in point being the Japanese banks. The more acceptable proposal is the second option,
which proposes to assign risk weights from 20 per cent to 150 per cent depending on
the rating, with un-rated banks being given the benefit of a lower weight of 50 per cent.
Even if these banks continue to be un-rated, the 50 per cent risk weight on claims on
them (up from 20 per cent as at present) would more than double the capital allocation
required by them on this account. And, if the banks do get themselves rated, then it is
very likely that several will receive ratings that qualify them for even higher risk weights.
While external ratings
Table 1: Proposed Risk Weights based on External Risk
Assessment
represent an important
Sovereigns Banks Corporates cornerstone of the New
Option 1 Option 2 Accord, as Monfort and
AAA to AA- 0 20 20 20 Mulder (2000) observe, such
A+ to A- 20 50 50* 100
BBB+ to BBB- 50 100 50* 100
overt reliance on external
BB+ to B- 100 100 100* 100 rating suffers from serious
Below B+ 150 150 150 150 limitations. For one, the
Un-rated 100 100 50* 100 relationship between
* Claims on banks of short-term maturity, e.g., less than 6 months would
receive a weighting that is one category more favourable than usual risk sovereign ratings and
weight on the bank’s claim. repayment risks is not well
Option 1: Based on risk weighting of sovereign where bank is tested. This issue has come
incorporated
Option 2: Based on assessment of the individual bank. to the fore, especially in the
aftermath of the Asian crisis,
wherein the credibility of external rating agencies has been seriously called into question.
Secondly, sovereign ratings could be pro-cyclical, although the professed aim of rating
agencies is to be cycle-neutral and avoid unforeseeable changes in ratings. More
importantly, the focus of rating agencies on default risk could limit their usefulness in the
New Accord. The focus of capital requirements should, in contrast, be on covering the
unexpected loss with a high probability (Jackson and Perraudin, 1999), i.e., to secure
bank soundness and limit the likelihood of insolvency (Greenspan, 1998). Therefore,
there appears to be a gap between the target of the New Accord (to provision against
unexpected loss), and the instrument (ratings), which measures ‘default risk’2. Internal
ratings by contrast, have several important advantages. Firstly, internal ratings potentially
incorporate proprietary information on bank clients that is unavailable to the public at
large and to rating agencies, if the borrower is unrated. The informational advantage of
internal systems could help generate more accurate credit risk assessments of the
borrower. Accurate assessments, in turn, could help to minimize the difference between
regulatory and economic capital. In addition, the use of internal ratings places the
responsibility of risk management squarely where it belongs viz. within each bank, a trend
the New Accord intends to encourage.
34 THE INDIAN ECONOMIC JOURNAL

V. Empirical Estimation
In the light of the aforesaid discussion, the purpose of the present study is to
understand whether credit rating is expected to significantly impact the capital adequacy
ratio of banks in India. Towards this end, we intend to examine whether credit rating
behaviour affect bank’s capital decisions. Accordingly, we have selected banks that have
been assigned short-term ratings by domestic rating agencies3,4. Since we cannot predict
with certainty whether capital adequacy ratio would affect bank ratings, we estimate the
probability that capital adequacy will impinge on ratings and hypothesize that this
probability is a function of a vector of explanatory variables. The econometric approach
used is the logit model, which is designed to identify the conditions under which one
observes one or another set of (n+1) discrete outcomes (Greene, 1997). Such
frameworks have been widely used in understanding the determinants of banking crises
(Demirgic-Kunt and Detragiache, 1998). Formally, the model’s dependent variable is an
indicator y that can take on values 0 and 1 that identifies two possible outcomes. The
model can be given a random utility interpretation 'a la Nakosteen & Zimmer (1980). The
explanatory variables X determine the ‘utility’ of each outcome according to the equation
U (alternative i ) = β 'i X + ψ i ; i = 1, 2 (1)
Here, X= X(k,t) is the vector of explanatory variables with k indexing banks (k=1…N)
and t indexing time (t= 1…T) and ψ denotes the error term. These ‘utilities’ can be
interpreted as the probabilities of observing the different outcomes, given the realization
of the explanatory variables. Note that the model allows the parameters βi to differ across
outcomes. For each observation, one obtains outcome i if it offers the maximum ‘utility’; in
other words,
U (alternativ e i) > U (alternativ e j) ∀ j ≠ i (2)
One can interpret this approach as assuming that the realized outcome for each
observation is that with the highest probability of occurrence under those conditions. As a
normalisation, the parameters β0 for alternative i=0 are set to zero, and the logistic
functional form is assumed, such that,
exp (β 'i X )
U (alternative i ) = (3)
∑ j=0 exp (β 'j X)
n

The model can then be estimated by a Maximum Likelihood procedure. Once the
parameters are estimated, it is possible to calculate the probabilities of occurrence of
each possible outcome, both within the sample and out-of-sample. For each observation,
the ‘predicted’ outcome is the one with the highest conditional probability.
Formally, let P(k, t) be the dummy variable that takes a value of one when the rating
of bank k indicates highest safety, and zero, otherwise. β is a vector of n unknown
coefficients and F(β β ’X(k,t)) is the cumulative probability distribution function evaluated at
β ’X(k, t). Then the log likelihood function of the model is:
Ln L = ∑ ∑ {P ( k , t ) ln [ F (β ' X ( k , t )] + (1 − P ( k , t ) ln [1 − F ( β ' X ( k , t ))]}
t =1 , 2 ,..., T k =1 .. N
(4)

When interpreting the regression results, it is important to note that the coefficients on
the RHS reflect the effect of a change in an explanatory variable on ln[P(k, t)/(1-P(k, t)].
Therefore, the increase in the probability depends on the original probability and thus
upon the initial values of the independent variables and their coefficients. While the sign
of the coefficient does indicate the direction of change, the magnitude depends on the
Volume 49, No.1 35

slope of the cumulative distribution function at β ’X(k, t). In other words, a change in the
explanatory variable will have different effects on the probability of rating, depending on
the bank’s initial rating status. The choice of explanatory variables is broadly conditioned
by the CRAMEL (Capital Adequacy, Resources, Asset Quality, Management Evaluation,
Earnings and Liquidity) approach. Therefore, the following variables have been used in
understanding the determinants of ratings: non-performing assets (GNPA), net interest
income (NIIWA), fee income (FIRWA), bank deposits (BDRWA), off-balance sheet activity
(OBSRWA), profits (PFRWA), provisions (PVRWA) and the hundred-per cent risk-
weighted assets (HRRWA), with all the variables being scaled by total risk-weighted
assets. While GNPA can be taken to proxy asset quality, profits and provisions act as a
proxy for earnings. Bank deposits reflect a vulnerability to run on deposits and can be
considered as a proxy for resources. The off-balance sheet item indicates the degree of
financial sophistication, while the 100-per cent risk weighted assets variable reflects the
riskiness of bank operations5. Our independent variable derives from the consideration of
the short-term rating assigned to the public sector banks by a domestic credit rating
agency (either CRISIL or ICRA). In such a case, we assign a dummy variable defined as:
RATE_SHORT = 1, if the rating reflects highest safety within the category = 0, otherwise
It needs to be mentioned here that we have only selected banks for which ratings are
available for all the quarters under consideration i.e. from 1997:Q1 to 1999: Q4. This
provides us with data on 18 banks that have been provided short/medium-term rating.
The ratings data are obtained from CRISIL and ICRA6.
Table 2: Determinants of Bank Ratings- VI. Analysis of the Results
1997:Q1 to 1999:Q4
Short-term
At the outset, it needs to be mentioned that
Variables it has not been the purpose of this exercise to
Dependent Variable: assess the impact of the new Accord, especially
RATE_SHORT
7.64
since it is still in its early days. However, what is
Constant intended is to raise some issues based on
(1.07)
Capital (t-1)
0.66 impending capital regulation, which could be a
(2.60)*
pointer to future work in the area. The results
-3.14
NIIRWA would therefore need to be interpreted with
(-3.25)*
FIRWA
10.71 caution.
(3.78)*
-0.14 The results of the panel data model for the
BDRWA
(-1.16) short-term ratings case is presented in Table 2.
-0.03 As evident from the analysis, high GNPA is
OBSRWA
(-1.25)
0.79 associated with a low rating, confirming the
PFRWA
(1.64)$ widely held belief that non-performing asset is a
1.74 critical factor in determining a bank’s rating. And
PVRWA
(2.62)*
-0.06 importantly, higher the GNPA, the higher is the
HRRWA
(-0.92) probability that a bank will receive a lower
-0.34 rating. The coefficient on the GNPA is negative
GNPA
(-3.50)*
2
R =0.62
in the short-term case, and is statistically
No. of observations 216 significant. Also, a rise in the 100-per cent risk-
Fraction of Correct
0.92 weighted assets appears to worsen bank rating,
Predictions
Log-likelihood -36.62
although it is statistically insignificant.
Figures in brackets indicate t-ratios. Unsurprisingly, profitability appears to play an
*, ** and *** indicate significant at 1, 5 and 10 important role in determining short-term rating
per cent, respectively. and is statistically significant. The provisions
variable too, has the expected positive sign in the short-term (and is statistically
36 THE INDIAN ECONOMIC JOURNAL

significant). Intuitively, higher the provisions in the short-run, the better is a bank
equipped to deal with adverse effects on their balance sheets. Higher net interest income
does not necessarily imply a higher rating, possibly reflecting the perception that the bank
is unable to diversify into non-fund activities. The primary focus of this exercise is to
understand whether capital has a significant impact on rating. Towards this end, the
analysis reveals that the short-run impact of capital on ratings might be significant and
greater amount of capital increases the probability of obtaining a better rating. Clearly, our
results are only a pointer, and a much more detailed analysis is called for before one can
predict with a reasonable degree of certainty what bank-specific and economy-wide
factors play an important role in determining bank ratings.
VII. Concluding Observations
With the Accord still in its early days, it might be too early to gauge the full impact of
the New Accord on the Indian banking system. Some simple conclusions however
suggest themselves. Claims on banks would overall attract higher risk weight, irrespective
of whether they continue to remain unrated or obtain ratings, internal or external since the
present ceiling of 20 per cent would now become a floor. With most corporates being
unrated, there would be no major change in the overall risk weights on good quality
assets, and there would even be lower risk weights for premium borrowers. However, net
NPAs would attract the 150 per cent risk weight from the 100 per cent at present and
hence require more capital to support them. And, if the second pillar of the Accord is
implemented, then an add-on can be expected for some banks, though some of this could
be met by the existing system-wise add-on of 1 per cent prescribed from the year 2000-
01. Yet, overall the conclusion is inescapable that the new Accord would require net
additional capital for the Indian banking system as a whole, though quantitative estimates
of this requirement seem to be unavailable at this juncture.
NOTES
1. Mingo (1975) is an exception. Yet, Dietrich and James (1983) show that Mingo’s findings of
significant regulatory influence is a proxy for binding deposit rate ceilings, which led banks to
increase capital to lure depositors.
2. Apparently, rating agencies concentrate on default risk for sovereigns because they have difficulty
capturing expected loss for sovereigns. This may reflect the general problem that defaults of
sovereigns are infrequently observed and depend on the willingness to pay and not only on ability to
pay.
3. Short-term ratings as those assigned to Commercial Paper/CDs.
4. In the Indian situation, given the lack of dispersion across ratings across PSBs, it does not seem very
meaningful to use external ratings for determining their implications for capital adequacy standards of
banks.
5. The details are contained in Nachane et.al.(2000).
6. The ratings data obtained from the two major domestic rating agencies, Credit Rating and Investment
Services of India Ltd. (CRISIL) and Credit Rating Agency of India Ltd. (ICRA) are conformable in
terms of their short/medium-term ratings assigned.
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