Emerging Banks Methodology

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Bank

CreditRisk

In

Emerging

Markets

July 1999

Contact Phone

London

Andrew Cunningham 44.171.772.5454Samuel Theodore

Limassol

Elisabeth Jackson-Moore 357.5.586586

New York

Nicholas Krasno 1.212.553.1653Jerome FonsChristopher Mahoney

So Paulo

Christiana Aguiar 55.11.3043.7186

RATING M ETHODOLOGY

Bank Credit Risk In Emerging Markets

(An analytical framework)

Rating M ethodology

continued on page 3

Rating

Methodology

1. Introduction

In April 1999, we published a Rating Methodology study entitled Bank Credit Risk: AnAnalytical Framework for Banks in Developed Markets. That study outlines the conceptual basis ofour approach to bank analysis worldwide. The purpose of this study is to highlight issues whichare of particular importance when analysing the credit quality of banks in emerging markets

around the world.


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2 Moodys Rating Methodology

Copyright 1999 by Moodys Investors Service, Inc., 99 Church Street, New York, New York 10007. All rights reserved. ALL INFORMATION CONTAINED HEREIN IS

COPYRIGHTED IN THE NAME OF MOODYS INVESTORS SERVICE, INC. (MOODYS), AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISEREPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FORANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODYS PRIORWRITTEN CONSENT. All information contained herein is obtained by MOODYS from sources believed by it to be accurate and reli able. Because of the possibi li ty ofhuman or mechanical error as well as other factors, however, such information is provided as is without warranty of any kind and MOODYS, in particular, makes norepresentation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitness for any particular purpose of any such information.Under no circumstances shall MOODYS have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to,any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODYS or any of its directors, officers, employees or agents inconnection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct,indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODYS is advised in advance of thepossibi li ty of such damages, result ing from the use of or inabi li ty to use, any such information. The credit ratings, if any, constituti ng part of the information containedherein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NOWARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OFANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODYS IN ANY FORM OR MANNER WHATSOEVER. Each rating or otheropinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user mustaccordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it mayconsider purchasing, holding or sell ing. Pursuant to Section 17(b) of the Securit ies Act of 1933, MOODYS hereby discloses that most issuers of debt securities (includingcorporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MOODYS have, prior to assignment of any rating, agreed to pay toMOODYS for appraisal and rating services rendered by it fees ranging from $1,000 to $1,500,000. PRINTED IN U.S.A.

Author

Andrew Cunningham

Editor

Giles OFlynn

Production Associates

Alba Ruiz, Susan Heckman


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Table of Contents

1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . CoverCommon Factors When Analysing Banks In Developed And Emerging Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

2. A Word On Semantics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

3. Emerging Market Bank Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53.1 Emerging Market Bank Universe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

3.2 The Evolving Role Of Emerging Market Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

3.3 Bank Credit Risk Is In Transition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

3.4 Syntax And Semantics Of Moodys Bank Ratings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

3.5 General Vs Specific Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

4. The Relationship Between Bank Ratings And Country Ratings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .94.1 The Role Of Bond/Deposit Ceilings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

4.2 The Relationship Between Country Ceilings And Government Bond Ratings . . . . . . . . . . . . . . . . . . . . . . . . . 9

4.3 Why Offshore Banks Can Be Rated Higher Than The Domestic Country Ceiling . . . . . . . . . . . . . . . . . . . . . 11

4.4 Local Currency Ratings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

4.5 The Significance Of Third Party Support . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

5. Key Differences Of Emphasis When Rating Emerging Market BanksAs Opposed To Those In Developed Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125.1 Financial Statistics And Ratios Are Less Valuable As A Way Of Measuring Bank

Strength And Of Comparing Banks With Each Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

5.2 The Economy And Environment In Which The Banks Operate Is A Much MoreImportant Driver Of Financial Strength . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

5.3 The Strength Of Capital And Provisions Is A More Important Element In The AnalysisOf Emerging Market Banks Than Is The Case With Banks In Developed Markets . . . . . . . . . . . . . . . . . . . . 13

5.4 In Emerging Markets, It Is More Frequently The Case That Bond And Deposit Ratings

Are Either Enhanced By The Likelihood That A Bank Could Be Supported In A Crisis,Or Constrained By The Limitations Of A Country Ceiling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14

6. Rating Methodology For Emerging Market Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146.1 Moodys Rating Methodology Is Not Based On A Checklist Or Scoring . . . . . . . . . . . . . . . . . . . . . . . . .14

7. The Banks Operating Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .157.1 Health And Structure Of The Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

7.2 Trends In Capital Markets, Disintermediation And Structure Of The Banking System . . . . . . . . . . . . . . . . . . . . . . 16

7.3 The Effectiveness Of Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

7.4 Assessing The Importance Of External Policy Influences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177.5 Transparency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

7.6 The Legal System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

8. Ownership And Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .198.1 Public Ownership And Privatisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

8.2 Private Ownership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

8.3 Why Governance Matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

(Continued)

Moodys Rating Methodology 3


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Table of Contents

9. Franchise Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219.1 Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

9.2 Market Position And Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

9.3 Market Share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

10. Earning Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2310.1 The Uses And Abuses Of Ratios To Measure Earning Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

10.2 The Importance Of Non-Interest Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

10.3 New Lines Of Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2410.4 Line Of Business Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

11. Risk Profile And Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2511.1 The Management Of Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

11.2 Credit Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

11.3 Market Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

11.4 Liquidity Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

11.5 Asset/Liability Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

11.6 Operational And Other Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

11.7 Year 2000 (Y2K) Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

12. Economic Capital Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3112.1 Why Does Capital Matter? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

12.2 Capital Ratios Are A Management Issue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

12.3 Does Regulatory Capital Matter? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

12.4 Using Economic Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

12.5 Economic Capital Generation Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

13. Management Strategies And Management Quality. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3313.1 Assessing Management Quality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

13.2 Agreements With Foreign Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

13.3 Strategies: Proactive, Or Management By Inertia? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

13.4 Mergers And Acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35



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Common Factors When Analysing Banks In Developed And Emerging Markets

Moodys believes that the techniques of bank credit analysis are transferable across different geographic

regions and across banking systems which are at different stages of development. Our approach toanalysing a bank in, say, Asia, is essentially the same as our approach to analysing a bank in the UnitedStates. For example, both such banks require strong business franchises in order to generate profits overthe long term. Both will need competent management teams in order to do this. In both cases, our analy-sis will assess the banks vulnerability to a deterioration in economic conditions and the effects of changesin the regulatory environment. And in both cases, we will consider the banks financial condition, both inabsolute terms and in relation to their peer groups.

But the relative importance which these, and other factors, play in our analysis may differ between adeveloped and an emerging market. This is the case throughout the world. Factors of analysis differ evenbetween developed banking systems. For example, during the 1980s, the effects of privatisation and dereg-ulation were an important consideration in our analysis of banks in some Western European countries.They were not factors which greatly influenced the credit quality of US banks at that time. So when weanalyse emerging market banks we are not engaged in a fundamentally different exercise from when weare analysing developed banks. We are always asking the same basic question what is the credit quality ofthis bank?

However it is true that analysts working on emerging market banks have to give greater emphasis tosome issues and less to others than is the case with banks in developed markets. Analytic tools which mayelucidate credit quality in developed markets may be less relevant in emerging markets, and vice versa. Thepurpose of this special comment is to highlight and explain those differences of emphasis.

2. A W ord On Semantics

Moodys does not have a definition of what constitutes an emerging market or an emerging marketbank. We think it is unlikely that anyone could arrive at a consistently defensible definition. Emergingbanks fill various points on a continuum which runs from the strongest and most sophisticated banksoperating in the strongest and most developed economies, to the weakest and most simple banks in theweakest and least developed economies. A single bank may display developed market characteristics insome areas of its operations while being unsophisticated in others. More importantly, we just dont thinkthe quality of our analysis would be enhanced by spending time trying to devise a definition. You willtherefore see references in Moodys reports to emerging markets, developing economies, transitionaleconomies and so on. We do however, recognise that definitions do sometimes have to be employed sim-ply in order to ensure a consistent processing of data. So for example the tables in Section 3 employ defin-

itions of emerging market economies employed by the IMF.

3. Emerging M ark et Bank Overview

3.1 Emerging M ark et Bank Universe

Moodys has ratings on nearly 1,000 banks worldwide, and about 40% of these are now in countries gen-erally considered emerging. Moodys coverage of emerging market banks has increased considerablyduring the last few years, as is evident from the table below.

Geographic Breakdown of Assigned Bank Financial Strength Ratings

April 1999

Europe and FSU(6%)

Latin America(10%)

Asia(13%)

Mid East/Africa(10%)

Industrialised excl. USA(35%)

USA(27%)

September April

1995 1999

Emerging markets 33 349

Industrialised countries

excluding USA 219 315

USA 288 248

Total 540 912


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Ratings of banks comprise the vast majority of our rating activity in emerging markets. This is becausebanks dominate financial intermediation in a way that is no longer the case in many of the more mature

economies. As financial markets develop, we expect that analysis of, for example, emerging market mort-gage banks, finance companies, corporate bonds and structured instruments will increase.

Our report on Bank Credit Risk ( An Analytical Framework for Banks in Developed Markets) identifiesfour large categories of banking institutions: (i)universal (federated) banks, (ii) large retail banks (iii) spe-cialised institutions and (iv) regional & local banks. Such distinctions are less applicable in emerging mar-kets. The distinctions which can be drawn tend to be between:

State-owned banks with specific mandates: eg development banks , agricultural banks; savings banks(Sperbank in Russia, Ceska Sporitelna in the Czech Republic, Caixa Economica Federal in Brazil); andbanks with other specific areas of responsibility (Bank Bumiputra Malaysia).

These banks are often heavily dependent on government business which may or may not be prof-

itable. They frequently suffer from very poor asset quality but benefit from regulatory forbearance orother forms of assistance. They typically have low financial strength ratings, but their deposit ratings areoften close to the country ceiling due to the strong likelihood that they would be supported by the stateduring a crisis.

State-owned banks with no specific mandate or whose original mandate has been subsumed in generalbanking business: for example, the four state-owned banks in Egypt or Banco Do Brazil or Krung Thai Bank. Their legal status is often that of a state-owned enterprise. These banks often have astronger business franchise than those with specific mandates but are often saddled with large amountsof non-performing government loans. Often they are legally state enterprises and have to contendwith bureaucratic controls and interference from politicians.

Private sector banks. The status of private sector banks varies greatly in emerging markets. In LatinAmerica they have been key players for many years. In some Middle East countries they have beenniche players but are now becoming more important as the role of the state sector diminishes. In someEastern European countries, private sector banks are a relatively new phenomenon. In Asia, privatebanks have long been an important element in many countries financial systems.

Ownership structures vary greatly and are often a key distinguishing feature of private sector banks.For example, some are owned by one or two business groups and are managed as house banks forgroup interests several Russian banks are like this. Some are closely held family concerns. But privatebanks also exist whose shares are publicly quoted and are managed on a wholly commercial basis.

Private sector banks are usually unburdened by severe asset quality problems from the past andhave a better earnings profile, since they target only business which offers reasonable returns (unlikestate-owned banks which may be obliged to undertake unprofitable business). They tend to have high-er financial strength ratings than state-owned banks, but their deposit ratings may be compromised bya lower predictability of support from state authorities in a crisis.

At the risk of oversimplification, one can say that the key distinction between different types of banksin emerging markets tends to be between state owned banks and private sector banks. But an importantfeature of emerging markets is that privatisation and deregulation is leading to rapid changes in the own-ership structure of the banking system. Not only do public sector banks pass into the private sector, butthe role which private sector banks play in the economy may change dramatically from being niche play-ers in a system dominated by publicly owned banks to being leading players. It is important for bank ana-lysts to look forward and ask what the banking system will look like in future, and which type of banks will

prosper in such an environment.

3.2 The Evolving Role Of Emerging M arket Banks

The banking system often has a dominant position within emerging financial markets. It is not just a ques-tion of the banks controlling financial intermediation between savers and borrowers. They also sometimesdominate all other areas of financial activity in their home markets, such as share brokerage, fund manage-ment, leasing companies and perhaps insurance. This dominance, when it occurs, reflects a lack of devel-opment in the local economy all countries need banks, but many have only recently become convinced


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of the utility of stock exchanges, or have liberalised their markets sufficiently to allow the creation of non-bank financial institutions such as consumer credit agencies. As liberalisation and deregulation permit the

creation of new financial institutions and products, banks are in the vanguard because few other domesticinstitutions have both the capital and the familiarity with financial markets required to enter such sectors.However, over time we would expect to see new market participants challenging the banks position onthe margin through the creation, for example, of independent brokers, consumer finance companies orleasing companies.

These trends have contradictory implications for the ratings assigned to banks. As financial markets

develop, opportunities increase for banks to diversify and enhance their earnings through new services andproducts. On the other hand, over the medium term, their earning power will be challenged by competi-tion from new players. The net effect of these two trends has to be considered on a case by case basis, butin general terms we believe that banks are more likely to prosper in a well-developed and predictablefinancial market which enables diversification of risk and of earning streams, rather than in a narrow andimmature market albeit one dominated by banks. As financial markets mature, it becomes easier for banksto be assigned higher financial strength ratings.1

3.3 Bank Credit Risk Is In Tra nsition

Many emerging market banks have a poor conception of bank credit risk. When this is the case, it is usual-ly because the banking system used to be controlled by the state which specified which sectors banks were

to lend to and the rate of interest to be charged. There was often little requirement to recognise that someborrowers often publicly owned companies were not actually repaying their debts, nor any require-ments to make provisions or preserve capital ratios. Banking was part of an internal system in which creditcirculated around various economic sectors. The accounting system, and ultimately the governmentsprinting presses, could be used to bridge the gap between economic policy and financial reality. Betweenaccruals and cash. The Chinese banking system remains an example of this type ofdirigiste banking.

Few central banks still allow this type of Panglossian accounting. Yet the credit culture (more precisely,lack of credit culture) which it engendered often survives long after the accounting norms and prudentialregulations have been changed. This is a very important factor for us when rating banks in these countries.We try to understand whether a bank has developed a credit culture based on analysing a clients ability to

repay loans in cash and on time, as opposed to, say, the bank relying on imputed state-guarantees, the valueof collateral (which may not be realisable in an underdeveloped legal system) or a long-standing personalrelationship between a branch manager and the general manager of the borrowing company. We believethat bureaucratic credit controls credit committees, authorisation limits and a refusal to allow any onemanager to approve a loan are a necessary but insufficient safeguard against poor lending practices. Overtime, a lack of a credit culture will undermine procedural safeguards such as credit committees. (Theimportance of management in determining bank credit quality is considered more fully below.)

3.4 Syntax And Sema ntics Of M oodys Bank Ratings

Moodys assigns the same types of credit ratings in emerging markets as it does everywhere else in theworld. The most common ratings are the debt and deposit ratings and bank Financial Strength Ratings

(FSRs). The debt and deposit ratings range from Aaa to C for long term debt and deposits and Prime-1 toNot Prime for short term. FSRs range from A to E.2

As financial markets mature, it becomes easier for banks to be assigned higherfinancial strength ratings

1 The development of financial markets brings risks as well as opportunities. Just as in developed markets, non-banking financial services (especiallysecurities trading and other investment banking businesses) contain substantially higher risks of losses and of earnings volatility, and this will be reflected inour analysis of a bank that is engaged in these activities, be it in New York or Kuala Lumpur.

2 Debt refers to bonds or notes, including MTN programmes.


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The debt and deposit ratings measure, a) the probability that the bank will default on its debt obliga-tions over their life and b) the expected monetary loss should such a default occur. In contrast, the FSRs, which were introduced in 1994, measure the banks stand alone financial strength without reference toeither sovereign transfer risk or implicit or explicit support from third parties. The FSRs should be seen asa sub-set of the debt and deposit ratings. They are not a substitute for them.

FSRs often receive more attention in the emerging market investor community than debt/deposit rat-ings. This increased attention is usually the result of most or all of the banks in a country being con-strained by a country ceiling (so the intrinsically strong banks receive the same deposit ratings as intrinsi-cally weak banks) or in a country where it is very likely that all banks would be supported in a crisis (sointrinsically weak banks are pulled up to the country ceiling and receive ratings similar to those assignedto strong banks). It should be remembered that FSRs can never substitute for debt/deposit ratings theymeasure two different things.

So for example, if an investor needs to compare the repayment ability of several banks and finds that

they have identical deposit ratings but different FSRs, the investor cannot use the FSRs to identify thebank with the strongest repayment ability. If their deposit ratings are the same, that means that theirrepayment ability is the same. But other investors whose priority is not repayment ability may wish tomake a distinction between the banks. To the extent that they wish to distinguish the banks by intrinsicfinancial strength, FSRs will enable them to do so. Where country risk has to be accepted if a transactionis to be completed the most acceptable counterparty may be the bank with the highest financial strength.

Moodys ratings are globally comparable and one result is that banks in emerging markets tend to havelower ratings than those in developed markets. The best bank in each market does not receive an A ratingfor financial strength. It can be the case and frequently is that the best banks in a country may be ratedno higher than D or D+ for financial strength. It is particularly difficult for banks whose business is basedin an unstable economic and financial environment to be assigned financial strength ratings at the higherend of the scale.

Moodys ratings are globally comparable the best bank in each market does not

receive an A rating for financial strength.


Moodys Rating Symbols*Long term debt/deposits Short term debt/deposits Financial Strength Ratings

Aaa Prime-1 AAa 1,2,3 Prime-2 BA 1,2,3 Prime-3 CBaa 1,2,3 Not Prime DBa 1,2,3 EB 1,2,3Caa 1,2,3CaC

* Notes:Long term ratingsRating levels other than Aaa, Ca and C employ modifiers. So Aa1 is higher than Aa2 which is higher than Aa3.Ratings of Baa3 and above are investment grade.Short term ratings

Short term ratings refer to instruments with a maturity of one year or less. All ratings other than Not-Prime are investment grade.Financial Strength RatingsA is the strongest, E is the weakest. A + modif ier may be attached to grades below the A level. The terms investment grade andsub-investment grade do not apply to FSRs there is no such thing as an investment grade financial strength rating .

Debt/Deposit Ratings Bank Financial Strength Ratings

Measure a banks repayment ability Measure a banks stand alone strength

Answer the question Will this bank be able to Answer the question, Will this bank need to berepay its debt obligations ? or If I put a dollar supported by a third party at some point in the future?with this bank, will I get it back ?

Use a rating scale from Aaa to C Use a ratings scale from A (highest) to E. A +signifier may be added to ratings B,C,D,E.


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3.5 Genera l Vs Specific Risks

Banking risk can be broadly divided intogeneral risks, which apply to all banks in the system and derive to

a large extent from a countrys economic strength, and specific risks, which are the product of the bankitself. In developed markets, it is hard to imagine that difficulties experienced by a bank can be solelyattributable to general risks, even though such risks certainly do have an impact on the banks perfor-mance -- in most cases bank failure is the result of mismanagement, risky strategies, rogue traders, etc. Inemerging markets, general risks loom larger. Not only can general risks be more severe but also it may bedifficult for any bank to avoid the consequences of a severe economic shock (such a massive currencydevaluation) or a deep economic recession.

Clearly, banks which are better managed and have stronger balance sheets are better placed to copewith general risks, but if general risks present a significant threat to the banking system it may well be thatno bank can be assigned an FSR at the upper end of the scale. For example, in the case of Lebanon, no

bank is rated higher than D because general risks include that of a severe devaluation and that the post-civil war reconstruction could stall. In those circumstances, even well managed banks with currently soundfinancial ratios may face difficulties. In some Asian countries devastated by the regions financial crisis Indonesia and Thailand for example the objective insolvency of all banks in the system is recognised bytheir financial strength ratings being E or E+.

4. The Relationship Between Bank Ratings And Country Ratings

No bank may be assigned a rating for foreign currency debt which is higher than the country ceilings forthe country in which it is based. In developed markets this is rarely a constraint, because country ceilingsare usually quite high often in the Aa range. But in emerging markets, the picture is very different.Country ceilings are lower and frequently do act as a constraint on the debt and deposit ratings assigned tobanks. As a result, country ceilings are a far more important determinant of bank ratings in emerging mar-kets than in developed markets. (As explained above, Financial Strength Ratings are notinfluenced by coun-try ceilings since they measure stand-alone strength irrespective of external constraints or external support.)

4.1 The Role Of Bond/ Deposit Ceilings

Before assigning bank ratings in a country Moodys assigns country ceilings which applies to all foreigncurrency bonds and deposits of banks in that country. These ceiling are notthe same thing as a govern-ment bond rating, although in practice, the two are nearly always set at the same level or in the case ofdeposits are at any rate closely linked. A government rating is a rating assigned to specific bonds issued bythe government of a country: for example, the Central Bank of Tunisia, the Federative Republic of Brazil.

It is therefore conceptually incorrect to say that no bank may be rated higher than the government ofthe country in which it is based, even though in practice such a statement nearly always holds true. Theconceptually correct statement would be no bank may be rated higher than the country ceiling of thecountry in which it is based, although it should be clear that this statement is tautological, since a countryceiling is a construct, the definition of which is the highest rating that could be assigned to any bankbond or deposit in that country. (Note that all these comments refer to foreign currency ratings. Localcurrency ratings are considered below.)

4.2 The Relationship Betw een Country Ceilings And Governm ent Bond Ratings

It is generally the case that the lowest-risk issuer of foreign currency in any country is the government of

that country. This is due not only to the large holdings of foreign currency which a government com-mands (foreign reserves, revenues from the export of state-owned commodities such as oil) but also to itsability to appropriate foreign exchange from other sectors of the economy in order to discharge its ownobligations. The simplest case involves a government imposing transfer restrictions whereby private sectorentities may not transfer abroad foreign currency and/or are required to deposit foreign currency with thenational authorities. The central banks regulatory powers, the governments legislative authority (and,ultimately, the governments monopoly of coercive force) enables it to do this.

This is not a theoretical point. When governments experience difficulties in discharging their own for-eign obligations they do in practice seek to alleviate their own difficulties by restricting the transfer and useof foreign currency by the private sector. And those measures tend to be effective. So when the Brazilian



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authorities faced difficulties in the late 1980s, they prevented Brazilian banks from discharging their for-eign currency obligations. There were some Brazilian banks which were not only able to discharge their

obligations but were very keen to do so in order to preserve their reputations, but they were unable to as aresult of the restrictions imposed by the authorities.

There is one major exception to this line of argument, and it helps to illustrate the underlying argu-ment being made:

The foreign currency bond/deposit ceiling in all 11 Euro-zone countries is Aaa, even in those coun-tries where government bonds are rated lower (e.g. Italian government bonds at Aa3). This is becausethe national governments of the Euro-zone no longer have the power to impose transfer restrictionson national banks that power has been ceded to the European Central Bank and we consider that thelowest credit risk in the Euro-zone is associated with the European Central Bank. As a result, anItalian bank (or corporate) could be rated higher than the Aa3 assigned to the Italian government.

Note that the potential for banks to be rated higher than their government is based on legal andinstitutional structures to which both are subject, and not on their relative creditworthiness. (Thoughof course creditworthiness will determine whether a bank was actually rated higher.) In emerging mar-kets we are sometimes presented with arguments that banks should be rated higher than their govern-ments because the banks are financially stronger. For example Lebanese banks point to their resilienceduring the countrys civil war, when most governmental functions broke down. But the Lebaneseargument does not address the key point that their government has the ability to impose restrictionson foreign currency transfers and, judging from the example of other countries, would likely do so in acrisis in order to preserve its own ability to discharge foreign currency debts.

While it is only in such specific and rare cases as the Euro-zone that country bond ceilings are notassigned at the same level as the government bond rating, it is much more frequent to see country depositceilings diverging from the country bond ceiling (and therefore also from the government bond rating). Inthe sub-investment grade range there is typically a one notch difference between the country ceiling forbonds and that for deposits, and in some cases that gap is wider. In Mexico the bond ceiling was Ba2 inJune 1999, and the deposit ceiling B1; in Korea Ba1 and Caa1; in Indonesia B3 and Ca. (Again, note thatall references refer toforeign currency .)

The crucial point to remember here is that a distinction is being made between two types of instru-ment bonds vs deposits rather than between issuers (banks vs governments)3.

The reason for putting the deposit ceiling lower than that for bonds is that in practice governmentsare more willing to impose transfer restrictions on deposits than they are on bonds. This is mainly becausethe consequences for a government of a bond default within its jurisdiction are greater than that of a

default on deposits. Bonds tend to be subject to tighter documentation and domiciled in international cen-tres, with the result that legal action in response to a default is easier to mount. Furthermore, bonds areoften bearer instruments, making it difficult to identify creditors and communicate with them. In contrast,deposits tend to be domestically registered. (For a full explanation of this point see our Special Comment,Sovereign Risk: Bank Deposits vs. Bonds, October 1995.)

The reason why a rating distinction is made between bonds and deposits in the sub-investment graderange and not in the investment grade range is that the greater riskiness of deposits derives from the con-sequences of sovereign action (that the government would restrict the transfer of foreign exchange). In theinvestment grade range the likelihood is remote that government would experience difficulties so seriousthat it would have to impose such restrictions. In the sub-investment grade range, a government event

becomes a much greater factor in the analysis, so predictions of how a government would act (i.e. that itwould make a distinction between bonds and deposits) becomes more important.

Sometimes, deposit ceilings may be set more than one notch below the bond ceiling. This would typi-cally occur if the banking system is particularly weak compared to other economic actors in the country.A decision to open up a gap of more than one notch is driven by theparticularcircumstances of that coun-trys banking system rather than by ageneralobservation of how bonds/deposits are treated as a class (as isthe rationale for the practice of always having a one notch gap in the sub-investment grade range).

(For more information on Moodys Sovereign Ratings see our Special Comment, Moodys SovereignRatings, A Ratings Guide, March 1999.)

3 Its hard to conceive of a distinction between issuers of deposits (bank deposits vs government deposits) since governments do not issue deposits.


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4.3 Why Offshore Banks Can Be Rated Higher Than The Domestic Country Ceiling

Offshore banks may be subject to a different higher ceiling than that assigned to domestic banks.

Although regulatory and legal authorities usually have the power to impede offshore banks registered intheir market from discharging their foreign currency obligations, there are compelling reasons in practicethat make it highly unlikely that the authorities would ever seek to do so, even during an economic crisis.

The first reason is that if the authorities were to interfere with the free flow of offshore funds, confi-dence in the offshore banking market would disappear and offshore operations would re-locate elsewhere. The second reason is that the authorities willingness to try to interfere would be conditioned by theirability to enforce any measures which they took. Offshore banks do not usually have a large amount ofdomestic assets which could be appropriated nor do they usually conduct a large amount of business in thehost country which could be jeopardised if they incurred the wrath of the local regulators. In sum, hostauthorities often have little incentive and only a limited capacity to interfere with cross boarder payments

of offshore banks even at times of crisis. As a result, Moodys has in several cases set the ceiling for foreigncurrency debt/deposits of offshore banks higher than that assigned to the foreign currency debt/depositsof the on-shore banks. (For more explanation of this point, see Moodys Special Comment, OffshoreBanking Centres and Country Risk, December 1997.)

Our analysis recognises that there are different types of offshore banks for example the offshore mar-ket in Bahrain comprises banks which are incorporated in Bahrain and have the seat of their operationsthere, and banks which are subsidiaries of international banks incorporated and headquartered elsewhere(eg, the Bahrain offshore bank of ABN-Amro). In the case of subsidiaries, the credit quality of the offshorebank may be influenced by that of its parent. So for example, the Cayman Island subsidiary of a Brazilianbank would be constrained by the Brazilian debt/deposit ceiling even though offshore banks in theCayman Islands may be rated as high as Aa3 or Aaa (depending on type of license).

4.4 Local Currency Ratings

Moodys sometimes issues ratings on local currency debt instruments and a key point about these is thatthe debt and deposits of banks can be rated higher than that of their home government. (As can the debtof any other private sector issuers.) Although there have been numerous cases during the last 50 years ofgovernments imposing restrictions on foreign currency transfers, it is extremely rare to see such restric-tions imposed on local currency transfers. The reason is partly that it is far more difficult for a govern-ment to restrict the transfer of local currency than it is to restrict the transfer of foreign currency. Theanalysis which underpins a local currency rating is more focused on the economic and legal environmentof the country, whereas a foreign currency rating is more focused on the governments financial ability to

discharge its debts. (The difference is one of emphasis, both ratings consider all these issues.) Thus thelocal currency rating looks at the risk of regime change or civil war, which could lead to a repudiation ofdebts; the predictability of the legal system; the depth and liquidity of the payment system; and the dangerof hyper-inflation (governments might impose payment controls in an attempt to forestall a descent intohyper-inflation).4

Rather than issuing ceilings as we do with foreign currency ratings, Moodys has internal local cur-rency guidelines which indicate the level which might be assigned to the financially strongest institu-tions in the country. The strongest issuer of local currency might not be the government.5Most local cur-rency ratings are significantly higher than equivalent foreign currency ratings.

4 There can be exceptions to this rating rationale: the main reason for the low local currency rating of Brazil is its possible inabili ty to discharge its localcurrency debts.

5 The argument that the government could always avoid a local currency default by printing more money is valid in theory but not in practice. In practice,governments do not generally print more money to avoid a payment crisis. One reason is that if they did so, hyper-inflation might result, destroying thewhole economic fabric of their society. Governments often conclude that hyper-inflation is too high a price to pay.


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4.5 The Significance Of Third Party Support

A banks repayment ability is not only determined by its intrinsic financial strength. A weak bank may

have a strong repayment ability if it is sure to be supported in a crisis by a strong third party (such as thegovernment, its shareholders, or market peers). Judging the predictability of such support is a particularlyimportant issue in emerging markets where many banks do indeed have weak intrinsic financial strength.

The predictability of support is frequently predicated on a view that a certain bank is too big to fail.Yet that idea encompasses a huge range of issues, and even the phrase itself is misconceived the correctterminology is too big to be allowedto fail. Governments almost always have the resources to save a bank,

so if a bank fails it is because the authorities have allowed it to do so. A full deconstruction of these issueswas published as a Moodys Special Comment Analysing the Predictability of Official Support for TroubledBanks, May 1997.6 On this occasion the following points should be highlighted:

It is rare for creditors to lose money as a result of a bank failure. Throughout the world, financialauthorities strive to avoid the repercussions which would affect their whole economy if one of theirbanks failed. We do not see this situation changing significantly any time soon, although regulators arealso conscious of the risks of moral hazard which arise from a strong predictability of support.

Despite this, we do think it is important to understand exactly why a specific bank or group of bankswould likely be supported in a crisis. We are very unimpressed by bland statements such as the gov-ernment would never allow a bank in this market to fail. The statement might be true, but we need tounderstand why. For example, it might be based on the fact that the country has been led by weak gov-ernments which cannot take unpopular action, such as allowing any constituency of voters to lose theirsavings. If a strong government emerges, the possibility of allowing this to happen might increase.

Timeliness of support is an important issue. Under Moodys definition, a bank which misses a pay-ment is in default even if all money due, and interest on missed interest, is eventually paid. As a result,one of the questions we consider is whether the government has a pre-arranged mechanism in placewith which to support banks during a crisis, and whether the government has determined in advancethe criteria which it would use to extend such support (eg, automatic support for the biggest fivebanks, but case-by-case decision for all the rest).

A strong predictability of support does not necessarily enable a bank to be rated at the country ceiling.Consider the hypothetical example of two banks, both equally likely to be supported in a crisis but one

of which is intrinsically weak and the other intrinsically strong. The fact that the weaker bank is morelikely to require support gives its repayment ability an element of uncertainty which does not exist forthe strong bank. The onset of a crisis might not be identified in time to get support in place; logisticalproblems might arise (eg, managers and regulators not in situ to deal with the problem); allowing abank to fail could be required as part of a economic support package being offered by external donors,and so on. Ceteris paribus, this increased uncertainty would be expressed by giving the intrinsicallyweaker bank a lower debt/deposit rating than the intrinsically stronger one.

5. Key Diff erences Of Emphasis W hen Rating Emerging M ark et BanksAs Opposed To Those In Developed M ark ets

5.1 Financial Statistics And Ratios Are Less Valuable As A Way Of Measuring Bank StrengthAnd O f Compa ring Bank s W ith Each Other

There are two reasons for this. First, disclosure is often less comprehensive and auditing standards less strictthan in more developed markets. Quite simply, the figures may not give an adequate picture of what is hap-pening at the bank, and they may even be misleading. For example, our June 1998 Banking System Outlook China noted that The financial performance of Chinese banks remains impossible for anyone to measure

A weak bank may have a strong repayment ability if it is sure to be supported in acrisis by a strong third party

6 Bear in mind that the concept of failure encompasses several scenarios. The closure of a bank may not lead to depositors losing money. Regulators couldtake control of a failed bank, which could then continue to conduct day-to-day business as before.


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accurately...published data may perhaps be best understood as an official means of carrying the official viewthat Chinese banks are financially strong and getting stronger in an orderly and controlled manner.

Second, numbers and ratios may be subject to enormous and rapid change in emerging markets, soeven figures which give a clear representation of a banks current position may have little value as predic-tors of future positions.

As a general principle, we believe that in emerging markets, published figures are more likely to be alagging indicator of a banks problems rather than a leading one. In emerging markets we cannot rely onpublished numbers to signal a developing problem. By the time it is signalled in the figures, the bank may

already be on the point of insolvency.

5.2 The Economy And Environment In Which The Banks Operate Is A Much More ImportantDriver Of Financial Strength

This is because the political and economic environment in emerging markets tends to be less stable thanin more developed markets, and because the scale of any change may be far greater. This is true at manylevels. For example:

A change of government may have a great impact on the structure of the banking system (for example,if an administration committed to privatisation replaces one which is not) and on the fortunes of indi-vidual banks (for example, in Turkey the chairmen of state banks are political appointees a problem

when governments change frequently). Banks may be affected by drastic measures taken by the government as part of its wider economic

agenda. For example in April 1998, we noted that in Brazil, a hike in interest rates to levels of 43%per annum in October 1997 from an already high 22%, coupled with a fiscal package aiming to savenearly R$20billion to the Federal Government are causing an economic slowdown and a contractionin credit demand. It is unlikely that any developed market bank would have to cope with such hugechanges in the monetary environment.

Banking systems in transition are by definition more subject to change than those which are mature.For credit analysts the main implication of this is that the competitive environment may change, exist-ing banks merge, new banks are created, the role and ownership of banks changed, and non-bank

financial institutions emerge to undermine historic business franchises. Competition will also comefrom foreign banks (with more sophisticated systems and far larger resources), depending on thedegree of openness of the market allowed by the government.

We would also point out that in markets where statistics may not be a useful guide to a banks financialstrength it is particularly important to understand the general forces which are shaping the banking mar-ket. Understanding the broader trends helps the analyst to interpret the figures presented by an individualinstitution. For example, the huge swings in Turkish banks returns on assets are hard to understandunless one appreciates the countrys hyper-inflationary environment.

5.3 The Strength Of Capital And Provisions Is A More Important Element In The Analysis OfEmerging M arket Banks Than Is The Case W ith Banks In Developed M arkets

In developed markets, a decline in credit quality usually occurs gradually as part of the business cycle giv-ing banks time to increase provisioning levels over a period of time. In emerging markets credit qualitymay deteriorate suddenly.

We believe that a strong earnings base is the best way to safeguard financial strength. Strong earningsenable a bank to consistently charge off a reasonable quantity of problematic loans without reducing itsequity, or to build capital and reserves against future contingencies. (Banks relative strength in this regardcan be compared through their ratios of pre-provision profit to net loans.) In emerging markets there is agreater possibility that banks earnings could be overwhelmed by a dramatic reversal in the economy. Insuch circumstances the bank may not be able to spread provisions over time but be forced to cover them

As a general principle, we believe that in emerging markets, published figures aremore likely to be a lagging indicator of a banks problems rather than a leading one.


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immediately from provisions and capital. As a result, the size of equity assumes greater importance. A keyratio of solvency in emerging markets is equity as a percentage of net loans. This ratio is an indication of

the proportion of a banks loans which it could charge off while still retaining positive net worth. (See sec-tions 11.2 and 12 below on credit risk and capital.)

5.4 In Emerging M arkets, It Is More Frequently The Case That Bond And Deposit Ratings AreEither Enhanced By The Likelihood That A Bank Could Be Supported In A Crisis, Or ConstrainedBy The Limita tions Of A Country Ceiling

The possibility that a government or other third party will support a failing bank plays a greater role indetermining debt and deposit ratings in emerging markets. This is partly because bank failure is often amuch more immediate possibility for an emerging market bank than for those in developed markets. Butalso, there are a greater number of intrinsically weak banks in emerging markets and some of these oper-ate in countries where the government has a reasonable ability to ensure that they do not default on their

obligations. For example, Tunisias Banque Nationale Agricole is rated E for financial strength, reflectingour view that the bank is extremely weak, yet it receives a foreign currency deposit rating of Ba1, becausethe Tunisian central bank (rated Baa3) would probably be able to prevent it defaulting in a crisis.

On the other hand, because the country ceilings assigned in emerging markets are lower than those indeveloping markets, it is more often the case that the ratings of strong banks are constrained. In NorthWest Europe, all country ceilings are Aa or higher, so few banks are likely to be constrained by a countryceiling. Emerging markets are rarely rated as high as the A category and usually quite a bit lower. Anotherway of conceptualising this is to say that banks face two main risks bankruptcy and a sovereign-imposedforeign currency moratorium. In the case of emerging market banks, the latter risk assumes a higher pro-file, and this translates into lower country ceilings.

6. Rating M ethodology For Emerging M ark et Bank s

Moodys rating model applies to banks throughout the world, regardless of where they are based, so theSeven Pillars of bank analysis outlined in our Rating Methodology paper on Bank Credit Risk in devel-oped markets also form the basis of our assessment of emerging market banks. Those Seven Pillars are:

1. Operating Environment

2. Ownership and Governance

3. Franchise Value

4. Earning Power

5. Risk Profile

6. Economic Capital Analysis

7. Management Priorities and Strategies

It is important to note that only two of these seven issues refers explicitly to a banks financial condi-tion earning power and risk profile. A banks financial condition today plays an important part in ouranalysis, but we believe that over the long term, issues such as business franchise and management qualityare more powerful drivers of bank financial strength. Banks sometimes make a case for a higher rating onthe sole basis that their financial ratios are better than those of other banks which are rated higher. Yet itis perfectly possible for a bank with weaker ratios to be rated higher if we believe that other more qualita-

tive factors will likely lead to stronger ratios over the long term.

6.1 M oodys Rating M ethodology Is Not Based O n A Checklist Or Scoring

We are sometimes asked what weighting we assign to different factors of analysis when arriving at a rat-ing is asset quality the most important factor, or is it capital ratios? The answer is that we do notapproach ratings in that way. The questions we ask ourselves is, What is driving the rating? What arethe features of this bank which are going to determine its credit quality positively or negatively overthe long term?


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The issues which have the potential to affect a banks credit quality are the same in every case: they canbe distilled into the seven pillars noted above. But in practice, the key issues driving the rating differfrom bank to bank. For one bank, a strong earnings profile may override concerns about forthcomingderegulation; for another, poor management may lead to a low rating despite strong financial indicators;and so on. The art of bank analysis lies in identifying the key rating drivers and assessing the extent towhich they will impact the banks credit quality over the long term.

7. The Banks Operating Environment

Operating conditions are the single most important reason why emerging market banks as a classreceivelower financial strength ratings than those in developed markets. When we assess the operating environ-ment, we ask the question, What opportunities do banks in this market have to build a diverse, strongand defensible earnings profile? We think it is intuitively obvious that it is easier to build such an earn-ings profile in a market which is mature, large, diverse and healthy, than in one which is not. Althoughmany emerging economies are large, they tend not to be mature; they are often based on a few sectors(such as mineral extraction), and the solvency of the government and the private sector may be precarious.

7.1 Health And Structure Of The Economy

In emerging markets our analysis begins with an assessment of the macro-economic environment. Factorsinclude prospects for economic growth, exchange rate stability and inflationary trends. For example, it isdifficult for a bank to be strong if the economy in which it operates is suffering a serious recession. Alternatively, a major currency devaluation could compromise an otherwise sound balance sheet.Compare, for example, the operating environment in any of the Euro-11 countries, with that in Russia.When we analyse banks in the Euro-11 states we can be very confident that they will not have to deal witha sudden bout of inflation, or a currency devaluation. We can also be fairly sure of the range in which eco-nomic growth will fluctuate over the next two or three years. In Russia, not only are those economic fac-

tors far less favourable, but they are also far less predictable. An unforeseen inflationary rise in Euro-landmight mean that inflation rises to 4-5% a year. In Russia, an unforeseen rise in inflation could mean anincrease to 200%!

(Bear in mind that this analysis is separate from the sovereign assessment mentioned earlier. In thiscase, we are looking at the underlying conditions in which the bank is operating and how they affect abanks intrinsic financial strength. We are not here assessing how those conditions affect the repaymentability of the government which could lead to the imposition of sovereign acts such as exchange con-trols. That analysis of sovereign acts is captured by the debt/deposit ceiling which applies to the ratingsof all banks.)

Operating conditions are the single most important reason why emerging market banksas a class receive lower financial strength ratings than those in developed markets.


Bank Analysts And Chess Players

Some years ago, scientists devised an experiment through which to investigate the differences between clubstandard chess players and chess grandmasters. Sensors were attached to the players eyes which showedthe scientists where on the chessboard the players were looking as they considered which moves to make.The difference between the two sets of players was striking. The club standard players looked all over thechess board, weighing up a wide range potential moves by a large proportion of the chess pieces available.In contrast, the grandmasters looked only at a handful of squares (a chess board has 64) and two or three ofthe pieces. They had identified the key squares and pieces which were driving the outcome of the game. Ofthe millions of potential moves available to them (and in chess, there areliterally millions) the grandmastersconsidered only few.

Moodys bank analysts strive to work like the chess grandmasters. We are aware of the miriad of issueswhich may affect a banks credit quality but we are focused on identifying those which are actuallydriving its

credit quality.


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The next stage of analysis is to look at the diversity and depth of the economy. Does the economy con-tain a large number of healthy enterprises covering a wide range of economic activities whose perfor-

mance contains some degree of negative correlation (so that if one sector is performing badly, others maystill be doing well)? The oil-exporting states of the Arabian Gulf provide an example here. The oil and gasindustry, which is almost wholly state-owned, accounts for at least one third of GDP, and private sectoractivity is heavily dependent on government contracts. Private sector activity which is not dependent ongovernment contracts barely extends beyond trading and import distribution. The result is that the cor-porate landscape of these countries is very limited. Furthermore, if the price of oil falls, government liq-uidity tightens (about three quarters of government revenues come from oil and gas sales). This does notonly affect those companies dependent on government business. Because government spending directand indirect is such a large part of total economic activity, nearly everyone is affected. It is therefore verydifficult for any bank to insulate itself from the influence of an economic slowdown. Some sectors will beaffected more than others, but all will be affected in some way.

7.2 Trends In Capital Markets, Disintermediation And Structure Of The Banking System

It is important to understand the banks role within the financial system as a whole. We said earlier thatbanks tend to dominate the financial system in emerging markets. This dominance gives banks two bigadvantages:

Pricing power banks are able to determine the going rate on deposits and loans, and on fees forfinancial services. This power need not be dependent on any cartel arrangements. It may be the outcomeof pricing inertia among the existing players (who have no interest in disturbing pricing structures) andthe absence of new players pursuing an aggressive pricing strategy in order to capture market share.

Ability to benefit from changes in the publics asset distribution for example, the effect of a move out

of bank deposits and into, say, mutual funds, is minimised if banks control the local mutual fund indus-try. Clearly, issues of funding and liquidity arise, but if banks can recapture in management fees themargin which they lose from deposit withdrawals, their profitability is protected.

As financial markets develop, new players appear and banks start to lose these two advantages. Thespeed at which this takes place depends on several factors, including the attitude of the regulatory authori-ties to licensing new institutions. Central banks are often very protective of their banking system, and donot want to see them weakened by new players. The speed of change will also be affected by the potentialfor capital market development a large economy with a diverse corporate landscape and a strong publicsector is more likely to attract the attention of local financial entrepreneurs and foreign institutions seek-ing a part of the action. A more staid market is likely to be left to the existing players.

The bank analyst therefore needs to consider the franchise which banks have within financial markets,and the likelihood that this will change. As we indicated earlier, more diverse and mature financial marketsare part of an improved operating environment, so some banks (winners) may benefit even if the fran-chise of banks as a classis weakened. Identifying winners and losers is a central part of this analysis.

Having considered the banks in the context of the financial system as a whole, the next step is to lookat how individual banks will be affected by the changing structure of the banking market. We look to seewhether the regulators are likely to licence new banks to compete with existing players, whether theyencourage or discourage mergers and acquisitions, and whether they will open the market to foreign com-petitors. In a market where the major players are growing bigger, possibly through mergers or strategicalliances with foreigners, smaller and weaker banks are likely to be marginalised. Under a non-competitiveand controlled banking system, such small banks may have been able to survive, but as markets are liber-alised stronger banks are able to pursue aggressive pricing strategies. Economies of scale also come intoplay. The most likely trend is for two types of institution to emerge large banks with a national franchiseand universal operations, and niche or regional banks. Those caught in the middle find it increasinglyhard to survive.

The countries of the Former Soviet Union and Eastern Europe have seen rapid changes in the struc-ture of their banking systems due to privatisation, the break-up of large banks, and the licensing of newplayers, both local and foreign. In that context, a bank which is a leading player today may not be sotomorrow. And since the regulation of banks is often a highly politicised issue, predicting the structure of


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the banking market involves understanding the policy platforms of competing political factions, and thelikelihood that they will get into power.

7.3 The Effectiveness Of Regulation

As in developed markets, we assess the ability of regulators to ascertain the soundness of banks in the sys-tem and also their capacity and willingness to intervene to prevent problems developing into crises. Thisinvolves assessing not only the competence of the regulators but also the influence which they wield with-in government circles. (A central bank rarely has sufficient resources to mount a major bank rescue thefunds must come from Ministry of Finance, and the Ministry may have different priorities and more influ-ence than the central bank.)

As regards the issue of competence, an analyst would want to know how regularly the central bankinspects banks and how detailed those inspections are. For example, if the regulators have only a handful

of staff with whom to inspect 50 banks, then the quality of inspection is unlikely to be very strong unless,as sometimes happens, independent auditors are called on to report on specific aspects of banking opera-tions. An analyst would also try to get a sense of how well regulators understand some of the more com-plex risks being faced by banks. For example, we have seen cases where regulators told banks to set up arisk management department without having any clear idea of what they wanted the banks to be measur-ing. The danger here is that the banks may be able to outsmart the people who are supposed to be super-vising them.

The willingness and ability of regulators to enforce regulations is another crucial issue. An analystshould ask what the regulators have done if they have discovered banks violating their rules, and whetherany have been closed down. This is an area where the scope of the bank analysts work extends beyondmeetings with bankers and regulators to include reading local press reports and maintaining contacts with

people such as journalists, lawyers and consultants. The fact that a small local bank was let off with a mildreprimand after violating regulations may not in itself seem significant. But if a major shareholder in thatbank is the relative of a government minister, then the event starts to look more troubling. That type ofbackground information is often essential to understand the true significance of events and it is rarelymade available by primary sources.

7.4 Assessing The Importa nce O f Ex terna l Policy Influences

External actors, such as the World Bank or the European Bank for Reconstruction and Development(EBRD) can have an important influence on the direction which a countrys banking system takes, and howlocal authorities might respond to a banking crisis. For example, when negotiating a support package with

the South Korean authorities in 1998, the World Bank and the IMF made clear their concern with themoral hazard which would result if all banks were supported unequivocally, although the Korean authori-ties very much wanted to continue exercising regulatory forbearance and support so that all could be pro-tected. Events such as the Mexican crisis of 1995, those in Asia during 1997/98 and the Russian default ofAugust 1998 have led to much more thought being given to the issue of external support for troubledeconomies. Going forward, it will be increasingly important for bank analysts to understand the policy pref-erences of multi-lateral institutions and of countries such as the USA which will be determining the cir-cumstances in which support is extended to emerging market economies and to individual banks.

7.5 Transparency

Emerging market banks and banking systems tend to be less transparent than those in developed markets,

and that is an important reason why they tend to be rated lower. Note that such lower ratings are not justa product of analysts conservatism, although that certainly plays a part (when information is incompleteor unreliable one has to be more cautious). Less transparency in a banking market leads directly to morebanking problems because banks in that market have to make business decisions based on incomplete orincorrect information and they are therefore more prone to making wrongdecisions.

It is also the case that lack of transparency is used to obscure problems when a financial system or abank is sound, regulators tend to advertise the fact. When it is not, they are more inclined to cover it up.Lack of transparency enables managers to postpone dealing with problems and continue to pretend thatnothing is wrong.


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When assessing transparency we are looking at two things:

the extent of disclosure about a banks operations and the macro-economy.

the reliability of that disclosure (Simply put, Is it true?)

At the level of individual banks, we would first ask whether banks report in line with internationalaccounting standards, including disclosure of impaired loans, market value of securities and fair value ofunquoted investments. We would also look for consistency of accounting, so that trends can be discerned.We are concerned if we see that a bank is constantly reclassifying items from previous years reports andwould want to understand why. As part of this analysis, Moodys analysts often ask local accountants fortheir opinion on local regulation and whether there are any specific areas where, in their opinion, trans-parency is weak.

The first stage in assessing the reliability of a banks disclosure is to check the auditors opinion in theAnnual Report, and to take a view on the value of that auditors opinion. Market intelligence should indi-cate whether any auditors have a reputation for being less strict than others. In our experience, the factthat a local accountant is affiliated with one of the big international auditors is not in itself a guarantee ofstrict auditing practices. Although market rumour and gossip should never form a basis for analysis, it mayalert the analyst to issues which can then be formally discussed with banks and regulators. It cannot bestressed too often that an emerging market bank analyst cannot depend solely on information receiveddirectly from banks and regulators.

We are concerned if we see that a bank frequently changes its auditor (except where regulators requirebanks to change their auditors every few years). Another warning sign would be an instance of a bank pub-lishing its annual results much later than it did the previous year. The delay may be due to a dispute withthe auditors or regulators.

Most of these warning signs should be evident from the banks Annual Report. The value of thorough-ly reading all the way through a banks Annual Report should not be underestimated. In particular, theinitial notes to the accounts covering the basis of presentation should not be overlooked, including, forexample, notes dealing with the basis of consolidation. In addition to answering specific questions the ana-lyst may have, the Annual Report also gives a good indication of a banks general attitude to disclosure.

Quality of disclosure is more important than quantity. The Israeli banking system provides an exam-

ple. Israeli banks Annual Reports run to some 200 pages, about 100 which comprise the notes to thefinancial statements. Yet, the analyst wanting to know an Israeli banks ratio of non-performing loans togross loans has a difficult task. The notes to the accounts do not show totalled numbers for non-perform-ing loans and gross loans. The number can be worked out but errors are easy to make if one is not alreadyfamiliar with Israeli banks. The philosophy behind Israeli banks disclosure appears to be classificationrather than explanation. Non performing loans are classified into numerous categories giving a far moredetailed breakdown than one would normally expect. But there is no attempt to consolidate that level ofdetail into the type of meaningful ratios which a credit analyst uses. Without considerable additional workby the credit analyst the numbers do not show whether the banks balance sheet is strong or weak. It is asystem designed for the benefit of regulators (whose priority is often classification) rather than for creditanalysts (whose priority is explanation). This is frequently the case in banking systems which used to be

state owned, like Israels.

We attach particular importance to the quality of public disclosure, as opposed to information submit-ted in confidence to rating agencies or other banks. Publicly disclosed information is subject to publicscrutiny and debate and may therefore be more accurate. (For more on the role of transparency seeMoodys Special CommentImproving Transparency in Asian Banking Systems, November 1998).

Quality of disclosure is more important than quantity.

It cannot be stressed too often that an emerging market bank analyst cannot dependsolely on information received directly from banks and regulators.



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7.6 The Lega l System

Understanding the legal system is an important element in emerging market bank analysis. A legal system

which is unpredictable, unenforceable, incomplete and corrupt diminishes the effectiveness of all aspectsof society. There are in addition several ways in which a faulty legal system directly affects the performanceof banks.

The main question is whether banks are able to receive redress in the courts against delinquent bor-rowers. The issue is not just whether the courts would ever rule in a banks favour. There is also the needto have that judgement enforced (so a debtors house has to be re-possessed or their assets seized). Andeven if judgement and enforcement are possible, if the whole process takes years and years, it may not beworth pursuing. A bank which knows that it will take five years to recover collateral from a delinquentdebtor even if the judgement goes in its favour is likely to cut a deal to recover a portion of what isowed. And of course debtors know that banks are going to face that choice.

In some societies, certain people appear to be beyond the reach of the legal system. Here the analyst hasto have some experience of the country concerned, and needs to speak to people outside the banking system.There are several areas of the world where banks insist that they can sue any borrower, however important,and obtain a judgement in their favour and where we (and they) know that that is simply not true.

There is another way in which the legal system has an important bearing on the banking system. Theanalyst should ask whether the legal system is facilitating or constraining the development of capital mar-kets. In many emerging markets, issues such as subordination/priority of claim have no clear basis in law.Securitisation, mortgages and even public share ownership may require changes in legislation before theybecome practicable. Egypt provides an example in the early 1990s Egypt was criticised for the lack ofprogress on its economic liberalisation programme, and there was no denying that government targets on

issues such as privatisation were routinely missed. But one area which did see considerable change was thelaws which governed capital markets. So for example, a forty year old law setting a maximum rate of inter-est of 7% on local bond issues was repealed. Banks were permitted to manage investment funds. Foreignbanks were permitted to operate in local currency. Without this overhaul of the legal framework govern-ing financial activity in Egypt, the development of Egyptian capital markets later in the decade would havebeen impossible.

8. Ownership And Governance

Strong and committed shareholders can have a positive influence on their banks debt/deposit ratingsbecause such shareholders would likely support their bank in a crisis. If those shareholders also strengthen

the banks business franchise and its financial condition, then they may also have a positive influence onthe financial strength rating. However, if the shareholders objective in founding the bank is to fund theirother business interests, and if close involvement of shareholders in the bank leads to low credit standards,there could be negative implications for the financial strength rating.

8.1 Public Ow nership And Privatisation

In emerging markets, public sector banks tend to be rated at or near the country ceiling for debt anddeposits because there is a strong likelihood that they would receive state support in a crisis. But publicsector banks are often inefficient and have large exposure to poorly performing public sector companiesand this in turn leads to low ratings for financial strength. If such institutions are privatised, the pre-dictability of support might immediately diminish and this could mean that the debt/deposit ratings are

lowered from the country ceiling. But over the long term, greater efficiency and more stringent creditcontrols might lead to a higher financial strength rating. Under this scenario, improved financial strengthcould start to drive the debt/deposit ratings higher (with repayment ability then being based on the banksintrinsic financial strength rather than on the presumption of support).7

Public ownership may give a bank an inside track to certain types of government business. It may alsoassist the bank to win large deposits from state-run pension funds and other government bodies. Thequestion for the analyst is whether this business is profitable, whether it is likely to remain so, and whetherany profitable government contracts could be transferred away from the bank to another. For example,

7 Privatisation is often advertised well in advance, enabling Moodys to factor into the ratings the likely loss of state support before it actually occurs.


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state-owned agricultural banks tend to have a monopoly on lending to farmers, but this is notoriouslyunprofitable business in a developing economy. Contracts which are profitable today may become unprof-

itable if the government changes the pricing structure. And the government could decide to assist an ailingpublic sector bank by transferring to it a lucrative contract held by another, stronger public sector bank.

An unfortunate consequence of state ownership is that the chairmen or general managers of banks arefrequently political appointees. Although usually there is continuity of appointments when governmentschange and often the intention is to appoint professional bankers (or competent businessmen) there canbe exceptions. In Turkey, banks see their chairman changed with every new government (and governmentturnover is quite rapid in Turkey). The result is not only instability, but also questions about the ultimateloyalty of a chairman is he concerned with the banks best interests, or those of the government?

8.2 Private Ow nership

The privatisation of banks in Europe generally led to higher ratings both for debt/deposits and for finan-cial strength. There is no reason why this should not also be the case in emerging markets. Private share-holders tend to demand higher rates of return than governments, and this forces management to focus onprofitability and efficiency.

Much depends on whether a small group of committed shareholders (or perhaps even a single share-holder) exercises effective control over the bank, or whether ownership is dispersed among a large numberof shareholders none of whom act in concert. This in turn tends to be driven by the governments privati-sation policy the analyst should be able to predict what sort of shareholder structure is likely to followprivatisation. Active and cohesive shareholders are likely to exert greater influence over the way the bankis run, whereas disparate shareholders will usually result in management retaining more freedom of action.

In some developing markets the trend from family-owned banks to professionally-managed banks isalso significant. When family owners are heavily involved in bank management analysts need to takegreater interest in succession issues and consider whether family members in the management team areperforming as well as outside professionals would. Transparency is also sometimes more limited in closelyheld family-owned banks. Without the need to be accountable to outside shareholders, it is easier forthese banks to choose the path of less disclosure. It is also important for the analyst to understand thatsome of the banks strategies may be influenced by

Documents

Emerging Banks Methodology