The Role of Credit Rating

Agencies

Manggi Habir
Director, Financial Services Ratings
November 22, 2004

The views expressed in this paper are the views of the author and do not necessarily reflect
the views or policies of the Asian Development Bank Institute (ADBI), the Asian
Development Bank (ADB), or its Board of Directors, or the governments they represent.
ADBI does not guarantee the accuracy of the data included in this paper and accepts no
responsibility for any consequences of their use. Terminology used may not necessarily
be consistent with ADB official terms.
 Agenda

8:15 a.m. Introduction

8:20 The Role of Credit Rating Agencies
• Rating Definition (What they are and not)
• Use of Ratings (Issuer and Issue)
• Track Record/Default Studies
8:45 a.m. Q & A Discussion
9:00p.m. Bank Rating Methodology and Criteria
• Sovereign Risk: Impact on Bank Ratings
• Economic and Industry Risk Methodology
• Rating Process
• Rating Analytical Methodology Proposal (RAMP)
9:40 Rating Example
10:00 Q & A Discussion

3/31/2006 2
 Who is Standard & Poor’s

A division of the McGraw-Hill Companies

Over 140 years’ experience in providing independent

financial information, analytical services and credit
ratings to the world’s financial markets

5,000 employees (inc. 1,250 analysts) in 19 countries

Credit ratings on more than 10,000 entities worldwide

3/31/2006 3
 Asia-Pacific Network – 2002

Hong Kong Standard & Poor’s

Jakarta PEFINDO
Melbourne Standard & Poor’s
Manila PhilRatings
Mumbai CRISIL
Seoul Standard & Poor’s
Singapore Standard & Poor’s
Sydney Standard & Poor’s
Taipei TRC
Tokyo Standard & Poor’s

3/31/2006 4
 What do we do?

Provide an independent and objective credit measure

in the form of a globally consistent rating scale to
players in the capital markets

3/31/2006 5
 What is a rating?

“Standard & Poor’s opinion on the general creditworthiness

of an obligor, or the creditworthiness of an obligor with
respect to a particular debt security or other financial
obligation”

Globally consistent against a standard scale

Measure of Default

Applied to entities and securities

Assigned in local and foreign currencies

3/31/2006 6
 What it is not

A recommendation to buy or sell investments

A way of defining good or bad companies

An audit

3/31/2006 7
 Some fundamentals

Ratings are forward looking – medium term time

horizon of 3-5 years

The objective is stability – they should not necessarily

reflect market volatility

The risk measured is probability of default and not

trading risk or loss given default

3/31/2006 8
 Relationship between ratings & cycles

Corporate Standard & Poor’s

AA performance Rating

BBB

Time

Examples: Automakers, Steel, European telcos.

3/31/2006 9
 Ratings definitions

Rating opinions assess:

– Issuer - capacity & willingness to meet financial

commitments
• Default baselines
– Corporate / company / issuer credit ratings
– Counterparty ratings
– Sovereign ratings
– Issue - creditworthiness of a specific financial
obligation
3/31/2006 10
 Types of ratings

Issuer Credit Rating (ICR) or Counterparty Credit

Rating (CCR)

Issue Rating

Programme Rating

Bank Loan Rating

3/31/2006 11
 Long-term rating scale

AAA Highest Credit Quality*

AA
A
BBB Ç Investment Grade
BB È Non-Investment Grade
B
CCC
CC
C
SD/D Debt in Selective Default / Default

3/31/2006 12
 Long-term rating definitions
“AAA” – “Highest rating …. obligor’s capacity to meet financial
commitment is extremely strong.”
“A” – “Somewhat more susceptible to adverse changes in
economic conditions …. capacity to meet financial
commitment is still strong.”
“BBB” – “Adequate protection …. but changes in economic
conditions could lead to weakened capacity…”
“BB” – “Faces uncertainties during adverse economic
conditions…”
“B” – “Possesses current capacity …. but likely to be
impaired…”
“CCC” – “Vulnerable to non-payment …. needs favorable
business climate to meet obligations…”
3/31/2006 13
 Short-term rating scale

Short-term A-1+ A-1 A-2 A-3 B

Long - term
AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB-

Debt with a maturity of one-year or less such as commercial paper.

Only the A-1 category is modified by a plus sign to distinguish
additional strength.

3/31/2006 14
 Ratings direction

Outlook:
– Given to all long term Standard & Poor’s Ratings except
some structured finance
– Assesses the potential direction of a long-term credit
rating over the intermediate to longer term (3-5 years).
– 4 options
• 1) Positive, 2) Negative, 3) Stable, 4) Developing
– Not necessarily a precursor to a rating change or Credit
Watch listing

3/31/2006 15
 Rating direction

CREDIT WATCH --
– Possible near-term change (usually within 90 days)
– Focuses on identifiable events and/or short-term trends
that deviate from expectations
– Additional information necessary
– 3 options
• Positive
• Negative
• Developing

3/31/2006 16
 Benefits of Credit Ratings to
Issuers/Counterparties

Supports disclosure & transparency

Provides independent peer comparisons

Enhances terms and conditions of borrowings

Enhances access to new sources of funds/markets

3/31/2006 17
 Benefits of Ratings to Investors

Assist in portfolio monitoring

Benchmark for risk premium

Information and reference point

Simple global measure of credit risk

3/31/2006 18
 Role of ratings

An independent benchmark of creditworthiness

Widely accepted by investors/counterparties as a

convenient and objective tool for differentiating credit
quality

Credit quality transparency = more efficient capital

market (finer pricing, wider access)

3/31/2006 19
 The utility of ratings

A third party to sort the abundant information available

Access to management

Independent viewpoint

Consistency

Wide universe of comparisons

3/31/2006 20
 Impact of ratings

Influence grown because of:

– Expansion in issuers/issuance volume

– Disintermediation and growing interest in credit among
investors
– High leverage of issuers cf. previous economic cycle
– Greater volatility of bond spreads and impact on equity

3/31/2006 21
 Data Summary

United States European Union

Emerging Markets Other

6000
US = USA + tax
Number of Issuers

5000 havens
4000 EU = European Union
3000 EM = Emerging Asia,
Latin America,
2000 Eastern Europe,
1000 Africa
0 Other = Canada,
Japan, New
Jan-81
Jan-82
Jan-83
Jan-84
Jan-85
Jan-86
Jan-87
Jan-88
Jan-89
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Zealand,
Australia

Source: CreditPro® 6.2

3/31/2006 22
 Revolution in debt markets

Pressures on commercial banks

Greater acceptance of debt leverage

Diversification of funding/flexibility

Institutional investor demand for yield

Enhanced liquidity of paper

3/31/2006 23
 Into the future

Bank market for core funding will becoming more difficult

Range of entities that can realistically use the capital

markets is growing

Ratings usage will extend beyond capital markets: Basel II,

commercial counterparties, regulatory, internal management

3/31/2006 24
 Elements of the New Basel Accord

Basel II

• Pillar I Pillar II • Pillar III

• Capital Requirements Supervisory Review • Disclosure

• Credit Risk • Establish globally • Required disclosures to

consistent review qualify for regulatory
• External ratings -
process capital treatment
Standardised Approach
• Intervene before capital • Recommended
• Internal ratings based
falls below minimum disclosures for
approach (IRB)
level transparency in terms
• Internal loss estimates
• Deal with risks that are of
• Credit Risk Mitigation not covered under pillar • Capital structure
• Asset securitisation I (e.g.IRR in banking
• Risk exposures
book)
• Capital adequacy
• Operational Risk • Assess factors external
to institutions

“Quantitative” “Qualitative” “Market Forces”

3/31/2006 25
 Capital Requirements
Under Pillar 1

Choice of Approaches

Credit risk

Standardised Foundation Advanced

Approach
IRB * IRB*

Risk External Internal Ratings

Assessment Ratings

Internal &
Data Inputs External Internal
External

Complexity of Approach

* Internal ratings based approach

3/31/2006 26
 Do we get it right?

Average cumulative 5-year probability of default

56.77%

31.99%

14.77%

3.53%
0.11% 0.28% 0.71%

AAA AA A BBB BB B CCC

Source: Standard & Poor’s Ratings Performance 2002
3/31/2006 27
 Do we get it right?

Average Spreads vs. S&P Rating Category

Euro-denominated Corporate Bonds S&P rated A & BBB
300
Basis Points over Swaps Curve

250

200

150 A
100 BBB

50

-50
02

02

02

02

02

02
2

3
00

00

00

00

00

00
20

20

20

20

20

20
/2

/2

/2

/2

/2

/2
0/

7/

6/
8/

6/

4/
15

13

10

/2

23

21
7/

8/

9/

/3

/2

/2
10
4/

5/

6/

1/

2/
10

11

12
Pricing Source: Bloomberg Generic Pricing

3/31/2006 28
 How transparent are we?

Ratings actions disseminated to whole market (and media)

simultaneously

Rationales, criteria and methodology published in full on

website

Intensive programme of explaining our analytical approach

to investors

Full transparency precludes move to subscriber model

3/31/2006 29
 An evolving approach

Enhanced Liquidity analysis

Focused accounting analytics

More emphasis on corporate governance

Improved and more frequent communication to the markets

– Quarterly report cards
– Credit bulletins

3/31/2006 30
 Information requirements

; Organisation ; Financial documents,

structure e.g. shareholder
; Senior management circular, issued over
background the last 3 years
; 5 years of detailed ; Detailed descriptive
historical financial data relating to the
info operations of all
; Detailed projections material divisions
for 3 years including ; Summary of
assumptions corporate strategy
; List of bank lines together with
available and recent perceptions of risks
usage and opportunities

3/31/2006 31
 Information requirements

Rating Request Analytical Team Preliminary

Appointed Research

Company Rating Meeting with

Informed Committee Management

Appeal Typical timescale 6-

Rating Issued
Process 8 weeks from
receipt of initial
information
Surveillance

3/31/2006 32
 S&P rating progression

3/31/2006 33
 Bank Credit Risk Analysis
S&P Bank RAMP
(Rating Analysis Methodology Profile)

OVERALL BUSINESS RISK RATING

Economic Risk Rating __________

Industry Risk Rating
Market Position Rating
Diversification Rating

Management / Strategy Rating

OVERALL FINANCIAL RISK RATING

Accounting & Financial Reporting

Credit Risk Rating
Earnings Rating
Liquidity and Funding Rating
Market Risk Rating

Capitalization Rating
Financial Flexibility Rating
OVERALL COMPANY RATING

3/31/2006 34
 Bank Credit Risk Analysis

Business Risk
• Economic risk
• Industry risk
• Management/strategy

Financial Risk
• Accounting & financial
reporting
• Credit risk
• Capitalization
• Earnings
• Funding & liquidity

3/31/2006 35
Bank Credit Risk Analysis

Economic Risk
 Economic Risk Analysis

Size and nature of economy and its vulnerabilities

Growth prospects
Business cycle -- volatility
Structural problems -- inflation, etc.
Sensitivity of economy to foreign investment
Openness of economy

3/31/2006 37
 Economic Risk Analysis

Constraints on government’s ability to pursue appropriate

counter cyclical policies

Country’s political stability

Dynamics of savings and investment

Level and growth of domestic credit

Structure and strength of corporate clients

Financial strength of individual clients

3/31/2006 38
 Leading Indicators of Financial
System Stress

Indicators of increased leverage (% GDP)

• Trend in credit growth (private sector and public enterprises)
• Corporate and household indebtedness
• Asset-price inflation
• Net external funding of financial institutions

3/31/2006 39
Bank Credit Risk Analysis

Industry Risk
 Industry Risk Analysis
Basic Structure

Number and relative size of banking institutions

Geographic or product restrictions
Size of bank loans in overall financial markets
Non-bank competitors
Depth of public capital market
Barriers to entry
Trends in industry

3/31/2006 41
 Industry Risk Analysis
Basic Structure

Equity holdings or other interlocking relationships

Political influence on bank lending decisions

Strength and efficiency of country’s legal system

Quality and transparency of accounting

3/31/2006 42
 Industry Risk Analysis
Customer Base

Price sensitivity

Level of sophistication of customers

Relationship between banks and corporate clients

3/31/2006 43
 Industry Risk Analysis
Regulation and Deregulation

State, national and international regulations

Trends in regulation
Regulatory structure -- level & quality
Regulatory structure -- degree of independence
Types of reporting by banks to regulators
Regulatory authority
Track record of regulators
Attitude of regulators toward bank support

3/31/2006 44
 Bank Credit Risk Analysis

Evaluating Management Strategy

 Management & Strategy

Management Factors
• Organizational structure
• Controls/information systems
• Performance vs. peers
• Credibility
Succession planning/special ownership
characteristics
Strategy
• Realism, logic and risk
• Implementation

3/31/2006 46
Bank Credit Risk Analysis

Accounting and Financial

Reporting
 Analytical Aim

Determine impact of such accounting and reporting on

quantitative aspects of analysis, e.g.,
• asset quality measures
• profitability measures
• capitalization measures
• liquidity

Determine impact of such accounting and reporting on

qualitative aspects of analysis, e.g.,
• management
• internal information systems

3/31/2006 48
 Financial Risk Analysis
Basic Financial Information

Generally, 5 years of audited financial reports but

exceptions exist

2 to 3 years of financial projections with:

• Detailed assumptions
• Sensitivities

3/31/2006 49
 Financial Risk Analysis

Rating process comparative

• Consistency of reported data key
– Understand accounting quality
– Adjust figures where possible to achieve comparability
– Cross-border comparisons
» Different accounting conventions
» Local risk factors

3/31/2006 50
Bank Credit Risk Analysis

Credit Quality
 Credit Risk Structure
Intrinsic Risk

Structure of on and off balance sheet credit exposures

• Amount and nature of fixed income securities
• Amount and nature of equity securities
• Nature and risk of loan portfolio
• Concentrations of loan portfolio

3/31/2006 52
 Credit Risk Management

Underwriting criteria

Monitoring of credit exposures

Quality of credit risk management information available

Problem loan management

Reserving policies

Reserve adequacy
3/31/2006 53
 Asset Quality
Intrinsic Risk

Characteristics within risk categories

• Size
• Maturity
• Currency
• Collateral
• Product concentrations
• Sector and borrower concentrations
– Look behind breakdowns in regulatory/ management reports;
can be misleading

3/31/2006 54
 Restructured Loans

Once restructured, loans should stay in this category,

even if paying according to new terms, if:
• The new terms are below market rate of interest
• Principal payments are unreasonably low
• Payment history under revised terms is too short OR
• Doubt remains about future payments

3/31/2006 55
 Foreclosed Assets

Question valuation -- long-term versus quick sale

Question ability to foreclose:
• Legal impediments
• Business impediments (political, relationships, public relations)
Question cost of foreclosure and sale
Question ability to sell asset:
• Special purpose nature
• General market liquidity in real-estate downturn

3/31/2006 56
 S&P’s Definition of Problem Assets

Non-performing loans per management

PLUS:
– Other loans that S&P considers problematic
– Restructured loans
– Securities with credit problems
– Foreclosed assets and assets received in lieu of foreclosure

3/31/2006 57
 Coverage of Potential Losses

Does it matter if:

BY BY
BY
COLLATERAL? PROVISIONS?
CAPITAL?

3/31/2006 58
 Coverage by Capital

In theory should work, but:

• Large amount of problem loans on balance sheet can create

negative perceptions;
• Reported capital overstated
• Reported profits overstated

3/31/2006 59
 Coverage by Collateral

Valuation!

Ability to realize value of collateral

Costs involved in realization
General market liquidity in real-estate downturn

3/31/2006 60
 Coverage by Provisions

Coverage of problem loans by provisions is clearly

Standard & Poor’s preference.

3/31/2006 61
 Charge-offs vs. Provisions

In countries where charge-offs are more rapid, net

charge-offs/loans are a better indicator of credit loss
record

In those countries, most or all on-balance sheet reserves

are general

OK if charge-offs exceed provisions in one or two years,

but not consistently

Recoveries/charge-offs a tool for evaluating conservatism

3/31/2006 62
Bank Credit Risk Analysis

Profitability and Capital

 Financial Risk Analysis
Earnings

Net Interest income: margin trends

Non-interest income: diversity and sustainability

Operating expenses: level and trend

Loan loss provision: current level, volatility

Net operating income analysis: level and trend

Quality of earnings: core earnings vs. trading, etc.

Extraordinary gains and/or losses

3/31/2006 64
 Financial Risk Analysis
Capitalization

Capital composition

Capital relative to level of risk

Capital relative to domestic capital requirements

Dividend payout ratio

Absolute size of bank’s capital

Ability to raise capital

Management philosophy regarding risk asset and loan leveraging, capital

projections

3/31/2006 65
 Key Capital Considerations

• Capital composition

• Capital relative to risk

3/31/2006 66
 Quality of Capital Considerations

S&P considers capital to be continuum, ranging from

tangible common equity (best) to traditional “vanilla”
subordinated debt (weakest form of capital)

In judging where particular instrument lies on

continuum, S&P looks at instrument’s ability to absorb
losses on ongoing basis

3/31/2006 67
 Capital Calculations
Adjusted Common Equity & Adjusted Total Equity

Standard & Poor’s tends to focus on Adjusted

Common Equity (ACE) as opposed to Tier 1 capital
and Risk Weighted Capital.

3/31/2006 68
 Capital Calculations
Adjusted Common Equity

Adjusted Common Equity is as follows:

Common “Plain Vanilla” Equity

plus Retained Profits
less Goodwill
less Asset Revaluation Reserves
less Investment in subsidiaries including insurance
companies accounted for on the equity method
less Deferred taxes deemed by S&P to be uncollectible
less Most Tier 1 adjustments required by the regulator
add Minority Interests

3/31/2006 69
Bank Credit Risk Analysis

Liquidity and Funding

 Financial Risk Analysis
Funding and Liquidity

• Composition of bank’s funding

• Diversity of funding sources

• Flows of funds

• Asset liquidity

• Liquidity policies

3/31/2006 71
 Retail Funding

Strong deposit base underlying strength of core

profitability:
• Generally ensures greater stability in net interest spreads throughout
cycles
• Core customer deposits (money market, savings, checking) generally
not as rate sensitive as CDs
• Higher the component of transaction accounts, the lower overall cost of
deposits
• High balance of non-interest bearing deposits driver of higher
profitability

3/31/2006 72
 Points to remember

Credit analysis is both quantitative and qualitative, not simply

formulaic

Consistent approach to analysing/adjusting local accounting

differences ensures international comparability

Ratings are medium/long term indicators of creditworthiness – but

only one aspect of market information

Methodologies/criteria evolve alongside developments in financial

markets …

3/31/2006 73
Bank Credit Risk Analysis

Support Factors in Bank Ratings

 Regulatory Support

Virtually all banking systems benefit from government

support via regulation
• Not guarantee timely payment of bank’s financial obligations
• Does mitigate some risks
• Part of industry risk assessment; not explicit factor in most bank ratings

3/31/2006 75
 Group Rating Methodology
Three Stage Approach

1. The global consolidated organization is assessed

2. Stand-alone and/or status quo ratings are assigned to the

primary operating companies

3. Each group member is designated as core, strategically

important, or non-strategic

3/31/2006 76
 Group Rating Methodology
Group Rating

• Consolidated or aggregated group is analyzed as if it were a single

corporate entity

• Group Rating is usually the same as Counterparty Credit Rating of

primary operating companies

• Group rating is reference point for ratings assigned to individual group

members

3/31/2006 77
 Stand-Alone Rating

• Assesses the group member as if it were a free-standing entity

• Removes all positive and/or negative effects of group membership

from the rating

• If the group member is not viable outside of the group, only a status
quo rating is assigned

3/31/2006 78
Bank Credit Risk Analysis

Sovereign Risk:
The Impact on Bank Ratings
 Risks Affecting Creditworthiness of Banks

Bank’s Own Financial Risk

Risk of Operating in a Country (Economic/Industry

Risk)

Risk of Sovereign Action (Intervention Risk)

3/31/2006 80
 Sovereign Intervention Risk

Exchange controls
Frozen bank deposits
Required repatriation of all funds held abroad
Implementation of restrictions on inward and outward capital
movement
Refusal to clear transfer of funds from one entity to another
Government-mandated moratorium on interest and principal
payments, or required rescheduling or restructuring of debt

3/31/2006 81
 Likelihood of Direct Sovereign
Intervention

Banks only rarely carry local and foreign currency

ratings higher than country’s ratings due to regulated
nature, ties to general health of economy, and fact they
are often instruments of government default. In addition,
usually have large government bond portfolios.

Corporates in non-regulated industries have somewhat

greater ability to achieve ratings above sovereign rating.

3/31/2006 82
 Mitigation of Sovereign Risk

External guarantees – explicit, full, unconditional, and

timely, covering full principal and interest

Issuer is “off-shore” operation

Geographic diversification

Structured finance

Preferred creditors (multilateral lenders, e.g., World

Bank)

3/31/2006 83
 Government Supported Entities Rating
Methodology

Analytical approach has shifted toward increasing

focus on stand alone credit quality
• Evidence in growing number of countries of reduction in government
commitment of public sector enterprises
– Privatization
– Occasional defaults
– Weaker statements of support
– Less use of government guarantees

3/31/2006 84
Snap Shot of Asia Banking System

• Asset quality improving

• Upward earnings trend
• Move towards a more diversified earnings
base
• Improved growth fundamentals
• More emphasis on risk management
systems
• Consolidation
 Regional Overview: Asia-Pac Banking
Outlook for Banking Sectors (nonpolicy)
Ratings are as at Aug. 19, 2003
Outlook Stable Stable Positiv Stable Stable Stable Stable Stable Stable Neg Stable Stable
e
Indone Phil Thai India China Malay Korea Taiwan Sing Japan HK Aust
AAA

AA

BBB

BB

CCC

3/31/2006 86
 Non-Performing Assets Ratios

Problem Assets (%)

50%
End 1998 (Est. Peak)
End 2002
40%
End 2003
30%

20%

10%

0%

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3/31/2006 87
 Adjusted Total Equity / Assets

Adjusted Total Equity-to-Average Assets Ratio

(%)
15
10 Average

5
0
2003
Philippines Hong Kong Malaysia Singapore
Taiwan Indonesia India China
Korea Thailand Japan

3/31/2006 88