RATING OF BANKS

Business Risk of Banks

• Business risk– Operating risk– Regulatory risk– Environmental risk– Ownership structure– Government support– Governance structure– Management strength– Risk positions– Risk strategy– Risk systems

Financial Risk of Banks

• Asset quality• Fund diversification• Liquidity of banks• Profitability of banks• Capital adequacy

Ratios used in Bank Rating

• Profile– Total asset base – Scale of operations– Net worth – Net income– Age of the bank

• Capital adequacy– Net worth as a percentage of assets– Capital formation rate – net income as a percentage

of net worth at the beginning of the year

Ratios used in Bank Rating

• Resources

– Deposit growth rate- increase in deposits over the

previous year

– Composition of deposits – mix of tem to savings and

current deposits

– Demographic profile of deposits - mix of deposits in

rural vs. other branches

Ratios used in Bank Rating

• Asset Quality

– NPA as a percentage of credit

– Gross NPA generation rate

– Provisions for NPA as a percentage of NPA

– Net NPA to tangible net worth

– Increase in total doubtful and loss assets as a percentage

of opening substandard assets

– Loan growth

Ratios used in Bank Rating

• Profitability– Return on assets– Return on net worth– Yield on earning assets– Cost of interest bearing liabilities– Gross interest spread – Net interest margin– Non interest revenue percentage– Non interest expense percentage– Dividend payout

Ratios used in Bank Rating

• Liquidity

– Liquid assets to deposits

– Certificate of deposits to deposits

– Credit as a percentage of deposits

Risk Based Rating

• Concept of larger bank resources to provide for larger

risks

• Identify risk from banking functions

• Grade the risk on the basis of its occurrence and impact

• Provide for resources in accordance with the risk grades

Risk Rating in Banks

• Rating System – Single Dimension

• CAMELS (Capital adequacy, asset quality, management

quality, earnings, liquidity, sensitivity to market risk)

• Rating System – Two Dimensional

• PF (Probability of failure)

• CGF (Consequences given failure)

CAMELS

• Capital component– Ability of capital to withstand risk from all components

of bank risk• Asset component

– Amount of credit risk with the bank (loan, investment and off-balance sheet)

• Management component– Ability of Board of directors and senior management

to identify, measure, monitor and control risks

CAMELS

• Earnings component– Quality and trend of earnings and ability of the bank to

sustain earnings• Liquidity component

– Sources of liquidity and funds position of the bank• Sensitivity to market risk component

– Changes in economic capital due to sensitivity of interest rates, foreign exchange rates, commodity prices and equity prices.

Profitability and Impact Rating System

• Developed in US, UK, Canada• Accounts for subjectivity• Considers objectivity

– Structured approach– Peer review– Quality control

Probability of Failure

Structured Approach

• Probability of Failure (PF) x Impact of Consequences Given Failure (CGF) = Index of supervisory attention

• Index of Supervisory Attention = Exponential from 1 to 56,000

• Index groups

• Normal

• Oversight

• Mandated Improvement

• Restructure possibility

Supervisory Attetntion

Application of Risk Grading

• Risk based supervision

• Identification of banks with high risk levels

• Inspection of banks that is mandatory and at increased

frequency

• Investigation of banks to contain risk

• Decisions on supervisory responses