Loan Rating under Basel II Framework

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Loan Rating under Basel II Framework

Subhash Nathuramka, FCS, Principal Consultant, Columbus Capital Management

Ltd., Mumbai.

Pursuant to Basel Committees’s norms, the RBI issued Guidelines in 2007 regarding

capital adequacy framework for banks operating in India. The mechanism of loan

e-mail : rating under Basel II framework has been explained here.

snathuramka@yahoo.com

INTRODUCTORY

Basel II is a recommendatory framework for banking

supervision, issued by the Basel Committee on banking

supervision in June 2004. The objective of Basel II is to

bring about international convergence of capital measurement

and standards in the banking system. It aligns regulatory

capital requirements more closely with underlying risks. The

Basel Committee members who finalized the provisions are

primarily representatives from the G10 countries, but several

countries that are not represented on the committee have

also stated their intent to adopt this framework. Over 100

countries including India have accepted it. RBI, in April

2007, has issued guidelines on the New Capital Adequacy

Framework to banks operating in India, based on the Basel

II framework. These guidelines replaced the ones issued in

April 1992 when RBI had implemented the first set of

recommendations of the Basel Committee, known as

Basel I.

Of late Indian banks have been moving towards risk based

pricing (by factoring in probable credit losses); borrowers

with better credit profiles have been benefited in the form

of lower rate of interest. However, till recently, regulations

did not allow banks to allow lower capital for borrowers

with better credit profiles and banks had to apply a uniform

100% risk weight to all exposures, irrespective of the

underlying credit risk. The Practice has undergone a change

under the Basel II approach. The guidelines for the

implementation of a new capital adequacy framework issued

by Reserve Bank of India (RBI) in April 2007 allows

commercial banks to allocate capital in relation to the credit

risk embedded in their exposures. Such embedded credit risks

are measured through ratings assigned by RBI approved

domestic rating agencies (External Credit Assessment

Institutions or ECAIs) like CRISIL, ICRA, CARE and

FITCH. Thus under the revised framework banks can lower

their capital allocation to as much as one fifth of the earlier

requirement for rated exposures depending upon the level of

external credit rating.

“Capital Adequacy” is the ratio of capital funds ( own funds

or net worth) to risk weighted assets. Under the Basel I

framework all assets were given a uniform risk weightage

of 100% while the stipulated minimum capital adequacy

ratio (CAR) for a bank was 9%. Under Basel II while the

minimum CAR is unchanged at 9% the risk weights

assigned to assets would be proportionate to the credit risk

of these assets.

As capital is the most expensive source of funding any

increase or decrease in such capital allocation could translate

into substantial savings/additional costs for banks. For

instance for exposures to investment grade (Triple B and

above) borrowers a bank could save on cost depending on

the cost of capital for the bank and the underlying credit

rating. If, however, the borrowers do not opt to get

themselves rated the bank concerned would be required to

maintain 50% additional capital;hence its cost could go up.

The banks may at their discretion decide to share the savings

achieved through lower capital allocation with investment

grade borrowers; at the same time given the pressures on

profitability banks may be forced to pass on the additional

costs for unrated exposures to their borrowers.

The revised framework for capital adequacy is effective from

March 31, 2008 for all foreign banks operating in India and

Indian banks having operational presence outside India (12

public sector banks and 5 private sector banks). It will apply

to all other commercial banks (except local area banks and

regional rural banks) from March 31, 2009. RBI has prescribed

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that all unrated exposures of banks over Rs.50 Cr. migrating

to Basel II w.e.f. March 31, 2008 would carry a 150% risk

weight for F.Y. 2008-09. The threshold is Rs.10 Cr. w.e.f.

April 1, 2009.

External rating can be sought for all types of loans, working

capital facilities, project loans, corporate loans, general

purpose loans, working capital demand loans, cash credit

facilities and non fund based facilities like letters of credit,

bank guarantees. Under RBI guidelines credit rating is not

mandatory. However in order to achieve saving in capital

requirement banks have started insisting on rating of credit

facilities by ECAIs.

Basel I v. Basel II – Risk Weights and Capital Required/Saving

Basel I Basel II

Capital Required Capital Saving

Risk Capital Risk Weights Rated Unrated Unrated Rated Rated

Weights Required for rated Exposures Category A Category B Category A Category B

exposures

AAA 100% 9% 20% 1.80% 9% 13.5% 7.20% 11.70%

AA 100% 9% 30% 2.70% 9% 13.5% 6.30% 10.80%

A 100% 9% 50% 4.50% 9% 13.5% 4.50% 9.00%

BBB 100% 9% 100% 9.00% 9% 13.5% 0.00% 4.50%

Category A= Existing exposures and < Rs.50 Cr. Fresh exposures/renewals

Category B= Fresh exposures/renewals > Rs.50 Cr.

For the initial two years exposures higher than Rs.50 Cr. will

have higher capital savings vis-à-vis exposures less than Rs.50

Cr. Subsequently all exposures higher than Rs.10 Cr. will have

higher capital savings.

Exposures less than less than Rs. 5 Cr. ( per entity) would

qualify as retail exposures and a risk weight of 75% would be

applied to them subject to fulfillment of criteria.

THE PROCESS OF RATING

The rating process by the agency is initiated on receipt of a

formal request ( mandate) from the prospective borrower.

Request can be made even during implementation stage of

the project. Request can also be made when the credit facility

from the bank is under process. A rating team with the

expertise and skills required to evaluate the business of the

borrower is involved with the rating assignment. The

borrower is given a list of information required and the broad

framework for discussions. The requirements are derived

from the rating agency’s understanding of business of the

entity and cover all aspects which have a bearing on the

rating.

RELEVANT INFORMATION

The rating agency would look into the following information

to be furnished by the entity-

􀂄 Detailed resume of Board of Directors, Key managerial

personnel

􀂄 Details of existing production facilities, capacities and

production, infrastructure and manufacturing processes

(including technology used) for each product.

􀂄 Details of capital expenditure, their funding patterns and

the benefits thereof.

􀂄 Product wise sales (value and volume), showing domestic

and export sales separately.

􀂄 Region-wise break-up (separately for each product) of

sales (volume and value).

􀂄 Country-wise break-up of exports (separately for each

product), if any, in value and volume terms.

􀂄 Break up of cost structure of each of the finished goods

on a per tonne basis for the last 3 years showing

materials costs (separately for each raw material),

consumables, power, other manufacturing costs and

overheads.

􀂄 Details of new projects, if any, including the description

of project(s), completion schedule, costs and funding

pattern, progress made/status of implementation, cost

incurred and sources of funds till date. Detailed

calculations highlighting the benefits (e.g. cost reductions

Loan Rating under Basel II Framework

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in various steps, higher capacities etc.) expected from

such project(s).

􀂄 List of major clients (top 10) for each product, sales

(volume and value) made to each of them. Company’s

credit terms offered to clients.

􀂄 List of major raw materials, sourcing arrangements and

credit terms enjoyed from the suppliers. Price trends for

each raw material for the last three years.

Finance Related

􀂄 Financial performance in the last 5 years.

􀂄 Details (interest rate and repayment terms) of all

borrowings.

􀂄 Account-wise debt repayment schedule and actual

repayments made in the last 5 years.

􀂄 Details of the sanctioned limits and month wise

utilizations of all bank limits (both fund and non-fund

based).

􀂄 Copy of the latest CMA.

􀂄 Latest audited financials of group companies, if any.

􀂄 Projections along with all underlying assumptions for

the next five years.

The rating agency also draws on secondary sources of

information including their own research. The rating involves

assessment of a number of qualitative factors with a view to

estimating the future debt servicing capacity of the entity.

This requires extensive interaction with the borrower’s

management especially on subjects relating to plans, outlook,

competitive position and funding policies.

Plant visits are made to gain a better understanding of the

production process, make an assessment of the state of

equipment and main facilities, evaluate the quality of technical

personnel and form an opinion on the key variables that

influence the level, quality and cost of production. These visits

also help in assessing the progress of projects under

implementation.

After completing the analysis a Rating Report is prepared which

is presented to the rating committee of the agency. The

committee has independent members who are qualified and

experienced in the field. The members with background of

banking are also inducted in the committee. A presentation on

the borrower’s business and management is also made the

Rating Team. The committee after careful consideration

assigns the rating.

The assigned rating along with rating rationale, is

communicated to the management of the entity for acceptance.

The process of rating takes three to four weeks.

If the entity does not find the rating acceptable it has a right to

appeal for a review. Such reviews are generally made only if

fresh inputs are provided. During a review the response from

the borrower is presented to the Rating Committee. If the

inputs and/or fresh clarifications so warrant the committee

would revise the initial rating. Non accepted ratings are not

disclosed by the rating agency.

The ratings once accepted are subject to regular periodic

reviews. The assigned rating may be retained or revised ( that

is upgraded or downgraded) following review.

The criteria for assigning bank loan ratings incorporate all the

features of the criteria applied for rating bonds and debentures.

However the criteria factor in features such as technical

defaults and minor differences in defining due dates that are

specific to bank facilities.

RATING METHODOLOGY

Business Risk Analysis

Industry Risk- Macroeconomic factors, Industry Structure,

Industry demand supply, Industry growth prospects, Industry

profitability, Market size, Extent of competition, Extent of

cyclical nature, Regulatory Environment.

Market Position-Key competitive advantages, Brand Strength,

Product profile, Pricing power, Distribution Network.

Operational Efficiency- Cost structure, Technological factors,

Access to resources, Labour Relations, Capacity Utilization,

Integration ( Forward and Backward), Flexible production

capacities, R & D capabilities.

Accounting Quality- Accounting Policies, Reporting and

Disclosure, Integrity of data.

Existing and Future Financial Position

Capital Structure, Profitability Analysis,Debt protection ratios,

Off Balance Sheet Obligations, Liquidity/short term factors,

Working Capital Management

Cash Flow Adequacy-Sources and Uses of funds, Cash

accruals in relation to debt payments, Capital expenditure plans,

Funding profile, Working Capital needs.

Financial Flexibility -Bank limits Utilization, Cash and

marketable securities, Access to capital markets, Relationship

with bankers, Contingency Plan Ability to defer capital

expenditure.

Integrity -Adherence to laws and regulations, Track record

Loan Rating under Basel II Framework

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of debt repayments, Inter group transactions, Reputation in

financial markets.

Risk Appetite -Financial Policy, Growth Plans, funding

profile, Unrelated diversification, Attitude towards business

risk, Risk management practices, Competence, Track

record, Consistency of performance, Success of past

strategies, Succession plans, Quality of senior management,

Experience in managing downturns, Ability to attract/retain

talent.

Governance Practices -Equitable treatment of shareholders,

Transparency and disclosures, Value creation to stakeholders,

Board Composition, Vision.

Project Risk Analysis -Project Evaluation, Project Size,

Implementation Risk, Funding Risk, Technology Risk, Track

record in timely implementation, Cost overruns, contingency.

Govt. support policy role - Strategic importance to the Govt.,

Criticality of sector to economy.

Implications of default/moral obligations - Political

implications of default, Public perception of sovereign

backing.

Group Support- Relevance of the entity to the group,

Percentage ownership by the group/promoters, Eco. Incentives

to the group.

Everybody would agree that any analysis in the above

framework is of immense value not only to the lending bank

but also the borrower entity as also its various stakeholders

viz. investors, creditors, customers, employees, and the Govt.

At the same time the analysis can become a guideline for the

entity towards making the necessary improvements in various

spheres of its working.

Rating : Enhancing Factors

Rating can be enhanced by the following factors -

􀂄 Leadership position in the market

􀂄 Consistency in production, turnover and profitability

􀂄 Consistency in cash flows

􀂄 Consistency in quality of products

􀂄 Wide acceptance and uses of the product

􀂄 Wide market (non dependence on certain regions,

customers)

􀂄 Wide distribution network ( domestic and overseas)

􀂄 Good quality of receivables

􀂄 Adherence to norms of corporate governance

(transparency in accounts, compliance with accounting

standards, compliance with environment regulations,

compliance with various statutes, dealings with

employees, suppliers, customers, govt., banks etc.)

􀂄 Integrity, competence and experience of promoter and

key managerial personnel

􀂄 Good Record of timely implementation of projects

􀂄 Proven technology to withstand competition

􀂄 Favourable industry scenario

􀂄 Strong presence of brand

􀂄 Low gearing

􀂄 Favourable key financial ratios like current ratio, TOL/

TNW, PAT/Net Sales, PBDIT/INTT, ROCE etc.

􀂄 Strong business model with suitable forward and

backward linkages

􀂄 Strong risk management system (involving

identifications of risks attached with every aspect of

business and putting into place measures to mitigate them

to the extent possible and feasible)

􀂄 Favourable government policy framework.

Rating : Constraining Factors

Rating can be constrained by the following factors-

􀂄 Cyclical nature of industry

􀂄 Dependence on Monsoon ( rainfall)

􀂄 Unhedged forex risk

􀂄 High gearing

􀂄 Small market share

􀂄 Inconsistency in production, turnover and profitability

􀂄 Inconsistency in cash flows

􀂄 Inconsistency in quality of products

􀂄 Limited acceptance and uses of the product

􀂄 Limited market (dependence on certain regions, customers)

􀂄 Poor quality of receivables

􀂄 Low on adherence to norms of corporate governance

(non transparency in accounts, non compliance with

accounting standards, non compliance with environment

regulations, non compliance with various statutes,

unsatisfactory dealings with employees, suppliers,

customers, govt., banks etc.)

􀂄 Low managerial competence of promoter and key

managerial personnel

Loan Rating under Basel II Framework

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􀂄 Unsatisfactory record of timely implementation of

projects

􀂄 Outdated technology

􀂄 Unfavorable industry scenario

􀂄 Unfavourable key financial ratios like current ratio, TOL/

TNW, PAT/Net Sales, PBDIT/INTT, ROCE etc.

􀂄 Non existent or incomplete risk management system

Indicative Rating Scale

Long term What does the ratings denote?

credit facilities

(Cash credit

Facility is also

treated as long

term facility)

AAA Highest credit quality rating. Shows lowest

credit risk. Highest safety for timely

servicing of loan obligations.

AA High credit quality rating. Shows very low

credit risk. High safety for timely servicing

of loan obligations.

A Adequate credit quality rating. Shows low

credit risk. Adequate safety for timely

servicing of loan obligations.

BBB Moderate credit quality rating. Shows

Moderate credit risk. Moderate safety for

timely servicing of loan obligations.

BB Inadequate credit quality rating. Shows

high credit risk. Inadequate safety for

timely servicing of loan obligations.

B Risk prone credit quality rating. Shows very

high credit risk. Low safety for timely

servicing of loan obligations.

C Poor credit quality rating. Very high

likelihood of default in servicing of loan

obligations.

D Lowest credit quality rating. Shows very

low prospect of recovery. Either in default

or likely to be in default soon.

Indicative Long term to Short term( maturity upto

365 days) Mapping

Long Term Rating Short Term Rating

AAA P1+

AA+ P1+

AA P1+

AA- P1+

A+ P1

A P1

A- P2+

BBB+ P2

BBB P2

BBB- P3+/P3

BB+ P4

‘+’ ( plus) and ‘-‘ ( minus) signs are applied from ‘”AA” to

“C” on the long term scale and from “P1” to “P3” on the

short term scale to reflect comparative standing within the

category.

Benefits to borrowers

Generally it is felt that the rating under Basel II is only aimed

at compliance with the capital adequacy norms for the lending

banks. However the rated entity is also benefited on several

counts such as-

􀂄 Being a rating from an independent and reputed agency

it is free from bias and has high credibility for all the

stakeholders of the rated entity.

􀂄 Although it is a loan rating methodology involved is

such that the final rating reflects not only the debt

servicing capacity of the entity but also the overall quality

of management, adherence to norms of corporate

governance, competitive position, industry scenario etc.

The rating rationale is made open to the public and is

displayed on the website of the rating agency. The rating

remains under surveillance and it can be reviewed on

the basis of feedback received from the entity, new

developments in the field.

􀂄 The borrowers may get pricing benefits, faster loan

approval, better terms flowing from the capital relief

for the bank.

􀂄 The rating can provide a higher level of comfort to the

prospective/existing lenders/investors.

BLRs will help develop a secondary market for loans and will

provide a uniform scale for analyzing credit risk of bank loans.

Over a period of time they will contribute immensely to the

development of a Credit Default Swap market.

Sometimes a question is asked as to the difference between

Loan Rating under Basel II Framework

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Comparison between internal rating/assessment by the banks and

rating exercise by external rating agency

Internal rating/assessment Rating by external rating

by bank agency under Basel II

Security Due weightage is given. Comfort level The aspect is given low weightage unless there

of bank increases with better quality of is some structured escrow payment mechanism

security. in place.

Cash flows and debt This is given high weightage. However This is given very high weightage. The

servicing ability perception of the bank may differ with assessment is made after taking into account all

that of external rating agency. relevant factors including nature of industry,

regulations, competitive position, operational

efficiency, quality of management, funding

policies of the borrower etc.

Transactions in account Small irregularities are condoned. Reasons All overdawings, irregularities in the operation

for overdrawings and other irregularities of the account are viewed seriously.

on genuine grounds are discussed and

remedial actions are taken.

Sector in which entity falls The sector specific decisions are made on The domestic and global position of the sector

the basis of RBI directives, internal is considered critical. Some sectors are in

management decisions. speculative category. In such cases higher ratings

become difficult to achieve.

Quality of management This aspect is viewed more in relation to The aspect of good corporate governance is

the satisfactory operations with the bank. considered important.

Leadership position in Small size of operations itself is not a Strong Leadership position in the market is seen

the market /Size of constraint as the bank sanctions need as a strong positive feature. Otherwise small size

operations based credit facilities with adequate of operations constrain the rating.

security.

Track record with the Satisfactory past track record is viewed Weightage is given keeping in view other criteria

bank as a positive feature and becomes which may at times outweigh this aspect.

foundation to further business with the

borrower.

CONCLUSION

Rating of loan under Basel II is a step taken by RBI in the

right direction. It will go a long way in not only ensuring

the proper capital adequacy for the banks but also guiding

the borrowers as well as lending banks to identify the key

factors governing the business of an entity and take the

remedial measures whenever required. The exercise of rating

also points towards greater emphasis on quality of cash flow,

proper business model and adherence to good corporate

governance rather than security coverage. Unlisted

companies, small businesses etc. can particularly be benefited

out of the rating exercise if only they can make it as a stepping

stone towards reforming their organization structures and

management styles. 􀂉

the internal rating/assessment made by the bank and the rating

exercise done by the external rating agency. Although it is a

subjective matter following comparison would clarify the

matter to a large extent-

Loan Rating under Basel II Framework

 

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