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Transcript of Credit Rating of Bank Financial by- Vrushank Mehta
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Project Report on
Credit Rating Procedure ofBanks/Financial Institutions
Submitted by
Vrushank Mehta
PGDBM Finance, 2005 07
Project Guide
Prof. Mohite
UNIVERSITY OF MUMBAI
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N.L.DALMIA INSTITUTE OF MANAGEMENT STUDIES AND
RESEARCH, MUMBAI
CERTIFICATE
This is to certify that the project entitledCredit Rating procedure of Banks &Financial Institutions is successfullycompleted by Mr. Vrushank Mehta duringPGDBM Semester IV in partial fulfillment ofthe course under University Of Mumbai
through N. L. Dalmia Institute OfManagement Studies & Research.
Prof. P.L.AryaProf. MohiteDirectorProject Guide
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ACKNOWLEDGEMENT
I wish to thank and express my gratitude tothose who extended their valuable co-operation and contribution towards theproject who took out of their busy scheduleand provided easy access to theinformation required.
I would also like to thank my project guideProf. Mohite for timely and unobtrusiveguidance given to me.
Also thanks to my friends and colleagues
for their enduring patience and valuablecriticism which shaped the project well.
Vrushank Mehta
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EXECUTIVE SUMMARYEXECUTIVE SUMMARY
The Reserve Bank of India (RBI), Indias central bank, is responsible for licensing and
supervising financial institutions and banks as well as non-banking financial companies.
Established in 1934, the RBI is vested with extensive powers under The RBI Act, 1934 and
The Banking Regulation Act, 1949 to monitor and regulate all commercial banks and
banking activities in India. The RBI has laid down guidelines on the prudential norms with
which it expects all commercial banks to comply. The areas covered include capital
adequacy, income recognition and asset classification, provisioning for non-performing
assets (NPAs), valuation of investments and other related matters. These guidelines are
based on the November 1991 recommendations of the Committee on the Financial System
(The Narasimham Committee)set up by the RBI and the subsequent 1998 suggestions of
the Committee on Banking Sector Reforms (the second Narasimham Committee). In recent
years, the RBI has been tightening its prudential norms to bring them into line with best
international practice. A basic precept of rating is that one should get to understand the
business of the bank in question, the objectives of its management, the environment it
operates in and the most likely future development of its business. This assists in arriving at
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a rating judgement rooted in an international perspective, which, nevertheless,
accommodates the particular circumstances of the bank (whether national, regional or
sectoral), preventing hasty pre-judgements based on criteria which are in one way or
another inappropriate. There are, however, certain universally applicable attributes of banks
asset quality is a good example - for which the rating agency considers it is possible, and
desirable, to set standards which have a degree of uniformity.
Table of contentTable of content
Topic PageNumber
Introduction 1
Rating Definition 3
Rating Process & Framework 11
Credit Rating Process Of Bank & Financial
Institution
15
Case Report I 32
Case Report II 54
Conclusion 56
Annexure-I 57
Annexure-II 65
Annexure-III 66
Annexure-IV 68
Bibliography 69
IntroductionIntroduction
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The primary objective of rating is to provide guidance to investors\creditors in determining
a credit risk associated with a debt instrument\credit obligation. It does not amount to a
recommendation to buy, hold or sell an instrument as it does not take into consideration
factors such as market prices, personal risks preferences and other considerations which
may influence an investment decision. The rating process is itself based on certain givens.
The agency, for instance, does not perform an audit. Instead, it is required to rely on
information provided by the issuer and collected by analysts from different sources,
including interactions in -person with various entities. Consequently, the agency does not
guarantee the completeness or accuracy of the information on which the rating is based. To
quote "In determining a rating, both quantitative and qualitative analyses are employed.
The judgment is qualitative in nature and the role of the quantitative analysis is to help
make the best possible overall qualitative judgment because, ultimately, a rating is an
opinion." Standard & Poors
Ratings, usually expressed in alphabetical or alphanumeric symbols, are a simple and easily
understood tool enabling the investor to differentiate between debt instruments on the basis
of their underlying credit quality. The credit rating is thus a symbolic indicator of the
current opinion of the relative capability of the issuer to service its debt obligation in a
timely fashion, with specific reference to the instrument being rated. It is focused on
communicating to the investors, the relative ranking of the default loss probability for a
given fixed income investment, in comparison with other rated instruments.
Credit Rating; as elucidated by the leading rating agencies of the world
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"A rating is an opinion on the future ability and legal obligation of the issuer to make
timely payments of principal and interest on a specific fixed income security. The rating
measures the probability that the issuer will default on the security over its life, which
depending on the instrument, may be a matter of days to 30 years or more. In addition, long
term ratings incorporate an assessment of the expected monetary loss should a default
occur." Moodys " Credit ratings help investors by providing an easily recognizable, simple
tool that couples a possibly unknown issuer with an informative and meaningful symbol of
credit quality." Standard & Poors
A rating is specific to a debt instrument and is intended as a grade, an analysis of the credit
risk associated with the particular instrument. It is based upon the relative capability and
willingness of the issuer of the instrument to service the debt obligations (both principal
and interest) as per the terms of the contract. Thus a rating is neither a general purpose
evaluation of the issuer, nor an overall assessment of the credit risk likely to be involved in
all the debts contracted or to be contracted by such entity.
RATING DEFINITIONSRATING DEFINITIONS
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Long Term Rating ScalesHigh Investment Grades
AAA
(Triple A)
Highest
Safety
Debentures rated `AAA' are judged to offer highest safety of timely payment
of interest and principal. Though the circumstances providing this degree of
safety is likely to change, such changes as can be envisaged are most
unlikely to affect adversely the fundamentally strong position of such
issues.AA
(Double A)
High Safety
Debentures rated 'AA' are judged to offer high safety of timely payment of
interest and principal. They differ in safety from `AAA' issues only
marginally.
Investment Grades
A
Adequate
Safety
Debentures rated `A' are judged to offer adequate safety of timely payment
of interest and principal; however, changes in circumstances can adversely
affect such issues more than those in the higher rated categories.BBB
(Triple B)
Moderate
Safety
Debentures rated `BBB' are judged to offer sufficient safety of timely
payment of interest and principal for the present; however, changing
circumstances are more likely to lead to a weakened capacity to pay interest
and repay principal than for debentures in higher rated categories.
Speculative GradesBB
(Double B)
Inadequate
Safety
Debentures rated `BB' are judged to carry inadequate safety of timely
payment of interest and principal; while they are less susceptible to default
than other speculative grade debentures in the immediate future, the
uncertainties that the issuer faces could lead to inadequate capacity to make
timely interest and principal paymentsB
High Risk
Debentures rated `B' are judged to have greater susceptibility to default;
while currently interest and principal payments are met, adverse business or
economic conditions would lead to lack of ability or willingness to pay
interest or principal.C
Substantial
Risk
Debentures rated `C' are judged to have factors present that make them
vulnerable to default; timely payment of interest and principal is possible
only if favorable circumstances continue.D
In Default
Debentures rated `D' are in default and in arrears of interest or principal
payments or are expected to default on maturity. Such debentures are
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extremely speculative and returns from these debentures may be realized
only on reorganization or liquidation.
Note:
1) CRISIL may apply "+" (plus) or"-" (minus) signs for ratings from AA to
D to reflect comparative standing within the category.
2) The contents within parenthesis are a guide to the pronunciation of the
rating symbols.
3) Preference share rating symbols are identical to debenture rating symbols
except that the letters "pf" are prefixed to the debenture rating symbols, e.g.
pfAAA ("pf Triple A").
Fixed Deposit Rating ScalesFAAA
("F Triple
A") Highest
Safety
This rating indicates that degree of safety regarding timely payment of
interest and principal is very strong.
FAA
("F Double
A") High
Safety
This rating indicates that the degree of safety regarding timely payment of
interest and principal is strong. However, the relative degree of safety is not
as high as for fixed deposits with "FAAA" rating.
FA
Adequate
Safety
This rating indicates inadequate safety of timely payment of interest and
principal. Such issues are less susceptible to default than fixed deposits
rated below this category, but the uncertainties that the issuer faces couldlead to inadequate capacity to make timely interest and principal payments.
FB
Inadequate
Safety
This rating indicates inadequate safety of timely payment of interest and
principal. Such issues are less susceptible to default than fixed deposits
rated below this category, but the uncertainties that the issuer faces could
lead to inadequate capacity to make timely interest and principal payments.FC
High Risk
This rating indicates that the degree of safety regarding timely payment of
interest and principal is doubtful. Such issues have factors at present that
make them vulnerable to default; adverse business or economic conditionswould lead to lack of ability or willingness to pay interest or principal.
FD
Default
This rating indicates that the issue is either in default or is expected to be in
default upon maturity.
Note: 1) The rating agency may apply "+" (plus) or"-" (minus) signs for ratings
from FAA to FC to indicate the relative position within the rating category
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of the company raising fixed deposits.
2) The contents within parenthesis are a guide to the pronunciation of the
rating symbols.
Rating For Short-Term Instruments (Commercial Paper)P-1 This rating indicates that the degree of safety regarding timely payment on
the instrument is very strong.P-2 This rating indicates that the degree of safety regarding timely payment on
the instrument is strong; however, the relative degree of safety is lower than
that for instruments rated "P-1".P-3 This rating indicates that the degree of safety regarding timely payment on
the instrument is adequate; however, the instrument is more vulnerable to
the adverse effects of changing circumstances than an instrument rated inthe two higher categories.
P-4 This rating indicates that the degree of safety regarding timely payment on
the instrument is minimal and it is likely to be adversely affected by short-
term adversity or less favorable conditions.P-5 This rating indicates that the instrument is expected to be in default on
maturity or is in default.Note : CRISIL may apply "+" (plus) sign for ratings from P-1 to P-3 to reflect a
comparatively higher standing within the category
Rating Scales For Structured Obligations (so)AAA(so)
(Triple A
SO)
This rating indicates highest degree of certainty regarding timely payment
of financial obligations on the instrument. Any adverse changes in
circumstances are most unlikely to affect the payments on the instrument.AA(so)
(Double A
SO)
This rating indicates high degree of certainty regarding timely payment of
financial obligations on the instrument. This instrument differs in safety
from `AAA' instruments only marginally.
A(so) This rating indicates adequate degree of certainty regarding timely payment
of financial obligations on the instrument. Changes in circumstances can
adversely affect such instruments more than those in the higher rated
categories.BBB(so)
(Triple B
This rating indicates a moderate degree of certainty regarding timely
payment of financial obligations on the instrument. However, changing
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SO) circumstances are more likely to lead to a weakened capacity to meet
financial obligations than for instruments in higher rated categories.BB(so)
(Double B
SO)
This rating indicates inadequate degree of certainty regarding timely
payment of financial obligations on the instruments. Such instruments are
less susceptible to default than instruments rated below this category.B(so) This rating indicates high risk and greater susceptibility to default. Any
adverse business or economic conditions would lead to lack of capability or
willingness to meet financial obligations on time.C(so) This rating indicates that the degree of certainty regarding timely payment
of financial obligations is doubtful unless circumstances are favorable.D(so) This rating indicates that the obligor is in default or expected to default.Note : 1) CRISIL may apply "+" (plus) or"-" (minus) signs for ratings from AA to
C to reflect comparative standing within the category.
2) The contents within parenthesis are a guide to the pronunciation of the
rating symbols.
Foreign Structured Obligations (Fso) Rating Scales
The credit rating agency has developed a framework for rating the debt obligations of
Indian corporates supported by credit enhancements extended by entities based outside the
country. The issues considered inter alia include the credit worthiness of the offshore
entity, the nature and structure of the credit enhancement mechanism to ensure timelypayments on rated debt obligations an regulatory issues as regards the transfer risk. The
credit rating would notch up the standalone credit ratings of these Indian issuers depending
on all these factors.
CRISIL ratings of Foreign Structured Obligations (fso) factor the credit enhancement
extended by an entity based outside the country. The ratings indicate the degree of certainty
regarding timely payment of financial obligations on the instrument. These ratings have
been assigned in the current regulatory framework as regards the transfer risk and any
change therein could impact the ratings.
The credit enhancements could be in the form of guarantees, letters of credit, asset backing
or other suitable structures. Due to the current regulatory controls on inward remittances,
CRISIL would require suitable liquidity mechanisms to be in place for ensuring timely
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payment on due dates.
Foreign Structured Obligations ratings are based on the same scale (AAA through D) as
CRISIL ratings for long-term instruments. Foreign Structured Obligations ratings symbols
are defined below:
High Investment GradesAAA(fso)
(Triple A)*
Highest Safety - This rating indicates highest degree of certainty regarding
timely payment of financial obligations on the instrument. Any adverse
changes in circumstances are most unlikely to affect the payments on the
instrument.AA(fso)
(Double A)*
Highest Safety - This rating indicates high degree of certainty regarding
timely payment of financial obligations on the instrument. This instrument
differs in safety, from "AAA(fso)" instruments only marginally.
Investment GradesA(fso) * Adequate Safety -This rating indicates adequate degree of certainty
regarding timely payment of financial obligations on the instrument.
Changes in circumstances can adversely affect such instruments. Changes
in circumstances can adversely affect such instruments more than those in
the higher rated categories.BBB(fso)
(Triple B) *
Moderate Safety - This rating indicates a moderate degree of certainty
regarding timely payment of financial obligations on the instrument.
However, changing circumstances are more likely to lead to a weakened
capacity to meet financial obligations than for instruments in higher rated
categories.
Speculative GradesBB(fso)
(Double B) *
Inadequate Safety - This rating indicates inadequate degree of certainty
regarding timely payment of financial obligation on the instrument. Such
instruments are less susceptible to default than instruments rated below this
category.B(fso) High Risk - This rating indicates high risk and greater susceptiblity to
default. Any adverse business or economic conditions would lead to lack
of capability or willingness to meet financial obligations on time.C(fso) Substantial Risk - This rating indicates that the degree of certainty regarding
timely payment of financial obligations is doubtful unless circumstances
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are favorable.D(fso) Default - This rating indicates that the obligation is in default or expected to
default.
Note: The contents within Parenthesis are a guide to the pronunciation of
the rating symbols.Credit Rating Scale for Financial Strength Ratings (FSR )
Ratings are broadly divided into two categories - Secure and Vulnerable. Rating categories
from "AAA" to "BBB" are classified as 'secure' ratings and are used to indicate insurance
companies whose financial capacity to meet policyholder obligations is sound. Rating
categories from "BB" to "D" are classified as vulnerable ratings and are used to indicate
insurance companies whose financial capacity to meet policyholder obligations is
vulnerable to adverse economic and underwriting conditions.
The opinion does not take into account timeliness of payment or the likelihood of the use of
a defense such as fraud to deny claims. For insurance companies with cross-border or
multi-national operations, including those conducted by branch offices or subsidiaries,
ratings do not take into account any potential that may exist for foreign exchange
restrictions to prevent policy obligations from being met. Financial strength ratings do not
refer to an insurance company's ability to meet non-policy obligations (i.e. debt
contracts).The ratings are not recommendations to purchase or discontinue a policy,
contract or security issued by an insurance company nor are they guarantees of financialstrength.
Secure Ratings
AAA Reflects Highest Financial Strength to meet policyholder obligations. Though the
circumstances providing this strength are likely to change, such changes as can be
envisaged are most unlikely to affect adversely the fundamentally strong position.AA Reflects High Financial Strength to meet policyholder obligations. Though the
circumstances providing this degree of strength are likely to change, such changes
as can be envisaged are most unlikely to affect adversely the fundamentally strong
position. Companies in this category differ only marginally from the 'AAA' rated
insurance companies.A Reflects Adequate Financial Strength to meet policyholder obligations. However, change
in circumstances can adversely affect such companies more than those in the
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higher rated categories.BBB Reflects Moderate Financial Strength to meet policyholder obligations. However,
changing circumstances are more likely to lead to a weakened capacity to meet
policyholder obligations than the higher rated categories.
Vulnerable RatingsBB Reflects Inadequate Financial Strength to meet policyholder obligations. While
companies rated in this category are less susceptible to default than other
speculative grade companies in the immediate future, the uncertainties that they
face could lead to inadequate capacity to meet their policyholder obligations.B Reflects Greater Susceptibility to default on policyholder obligations. While current
obligations are met, adverse business or economic conditions would lead to lack of
ability or willingness to meet policyholder obligations.C Vulnerable to default. Ability to meet policyholder obligations is possible only if
favourable circumstances prevail.D In default. Current policyholder obligations are in default. Insurance companies
rated "D" are extremely speculative and policyholder obligations may be realized
only on reorganization or liquidation.
Financial strength ratings from "AA" to "BB" may be modified by use of a plus (+) or (minus
(-) sign to show the relative standing of the insurance / reinsurance company within the
rating categories.
Bond Fund Rating Scales
AAAf The funds portfolio holdings provide very strong protection against losses from
credit defaults.AAf The funds portfolio holdings provide strong protection against losses from credit
defaults.Af The funds portfolio holdings provide adequate protection against losses from
credit defaults.BBBf The funds portfolio holdings provide moderate protection against losses from
credit defaults.BBf The funds portfolio holdings provide inadequate protection against losses from
credit defaults.Cf The funds portfolio holdings have factors present which make them vulnerable to
credit defaults.
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Rating Process & FrameworkRating Process & Framework
Rating is an interactive process with a prospective approach. It involves series of steps. The
main points are described as below :
( a ) Rating request : Ratings in India are initiated by a formal request (or mandate ) from
the prospective issuer . This mandate spells out the terms of the rating assignment .
Important issues that are covered include : binding the credit rating agency to maintain
confidentiality , the right to the issuer to accept or not to accept the rating and binds the
issuer to provide information required by the credit rating agency for rating and subsequent
surveillance.
( b ) Rating team :The team usually comprises two members. The composition of the
team is based on the expertise and skills required for evaluating the business of the issuer.
( c ) Information requirements : Issuers are provided a list of information requirements
and the broad framework for discussions. These requirements are derived from the
experience of the issuers business and broadly conforms to all the aspects which have a
bearing on the rating. These factors have been discussed in detail under Rating framework.
(d) Secondary information :The credit rating agency also draws on the secondary sources
of information including its own research division. The credit rating agency also has a
panel of industry experts who provide guidance on specific issues to the rating team. The
secondary sources generally provide data and trends including policies about the industry.
(e) Management meetings and plant visits : Rating involves assessment of number of
qualitative factors with a view to estimate the future earnings of the issuer. This requires
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intensive interactions with the issuers management specifically relating to plans , future
outlook , competitive position and funding policies.
Plan visits facilitate understanding of the production process , assess the state of equipment
and main facilities , evaluate the quality of technical personnel and form an opinion on the
key variables that influence level , quality and cost of production. These visits also help in
assessing the progress of projects under implementation.
(f) Preview meeting:After completing the analysis, the findings are discussed at length in
the internal committee, comprising senior analysts of the credit rating agency. All the
issues having a bearing on the rating are identified. At this stage , an opinion on the rating
is also formed.
(g) Rating Committee meeting:This is the final authority for assigning ratings. A brief
presentation about the issuers business and the management is made by the rating team. All
the issues identified during discussions in the internal committee are discussed. The rating
committee also considers the recommendation of the internal committee for the rating.
Finally, a rating is assigned and all the issues which influence the rating are clearly spelt
out.
(h ) Rating communication : The assigned rating along with the key issues is
communicated to the issuers top management for acceptance. The ratings which are not
accepted are either rejected or reviewed. The rejected ratings are not disclosed and
complete confidentiality is maintained.
( I ) Rating Reviews : If the rating is not acceptable to the issuer , he has a right to appeal
for a review of the rating . These reviews are usually taken up only if the issuer provides
fresh inputs on the issues that were considered for assigning the rating. Issuers response is
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presented to the Rating Committee. If the inputs are convincing, the Committee can revise
the initial rating decision.
( j ) Surveillance : It is obligatory on the part of the credit rating agency to monitor the
accepted ratings over the tenure of the rated instrument. As has been mentioned earlier, the
issuer is bound by the mandate letter to provide information to the credit rating agency. The
ratings are generally reviewed every year, unless the circumstances of the case warrant an
early review . In a surveillance review the initial rating could be retained or revised
(upgrade or downgrade ).
How Does the Ratings Process Work?
The process of Rating starts with the issue of the Rating Request by the issuer/ signing of
the Rating agreement. A detailed flow chart is as under:
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Limitations of Credit Ratings
A Credit Rating is an assessment carried out from the limited standpoint of credit risk
evaluation. A Credit Rating from rating agency therefore constitutes a current Opinion on
the credit quality of a specific issue of debt, in terms of the issuers ability and willingness
to meet principal and interest payments on rated debt instruments in a timely manner.
Credit Ratings are arrived at based on information obtained in the rating process. In
addition to management meetings and information provided by rated entities, the rated
entitys audited accounts, regulatory filings, and information provided by trustees form an
important source of information. CRISIL does not verify and validate all the information
that it uses for its ratings. However, reasonable due diligence is carried out on all
information used to the extent feasible to ensure that a meaningful and accurate rating
exercise is done (for instance, financial accounts are extensively adjusted to ensure that
they present a relevant picture of the financial position of an entity from a debt servicing
perspective, to the extent feasible).
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Rating process for Bank/Financial institutionRating process for Bank/Financial institution
Once we have received a request for a new rating of a bank (this should subsequently be
backed by a formal rating agreement), we follow the procedures outlined below:
1. Analyzing the Banks/FIs environment
It is first necessary to collect and analyze data relating to the it system in which the
Banks/FIs in question operates and to the place of the Banks/FIs within that system. This
process includes analysis of the relevant national Banks/FIs market and of existing and
potential competition in that market and also of the degree of concentration within it. It
requires examination of the role and functions of the Banks/FIs supervisory authorities in
the country in question, of the degree of state control (or decontrol) of that countrys
Banks/FIs system, of the requirements of public reporting Banks/FIs and of the
accounting practices that lie behind the figures publicly reported by Banks/FIs. On a still
wider scale it is necessary to take into account the requirements of the Basle G 10
Agreement on "International convergence of capital measurement and capital standards"
and subsequent interpretative statements from the Basle Committee (of international bank
supervisors).
2) Bank questionnaire:
Based on our initial analysis of publicly available data, we prepare a questionnaire for
presentation to the management of the bank to be rated. A copy of our "prototype"
questionnaire is attached as Appendix 1. This is intended to serve as a basis which may be
adapted for the particular circumstances of the bank being rated.
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3) Meeting with bank:
As already indicated, the next step is a meeting with senior management of the bank in
question to discuss and assess the data provided. Such meetings are usually arranged with
the bank's chief financial officer, but many of the more sophisticated banking groups and
banks now employ rating agency liaison officers. The length and number of meetings with
management depend on the complexity of the entity being rated, but, normally the first
time we rate a bank there will be one such meeting, and it will last for half a day to a day.
4) Analysis of the bank:
The Cramel Model comprises the following:
I. Capitals adequacy ratio
II. Resource raising ability
III. Asset quality
IV. Management & system evaluation
V. Earning potential
VI. Liquidity / Asset Liability Management
NO one factor has an overriding importance or is considered in isolation.
These entire six factors are viewed in conjunction before assigning rating.
In addition to the factors which constitute the CRAMEL, the size of the financial entity is
also an important parameter. The size of an entity in the financial sector, imparts it the
ability to with stand systematic shock, support that can be expected for the entity.
I CAPITAL ADEQUACY:
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Capital adequacy of an entity provides the necessary capital cushion to with stand credit
risks. While assigning a rating, it analyses the capital adequacy level and its sustainability
in the medium to long term. The analysis of capital adequacy encompasses the following
factors:
I.1 Size of capital:
The absolute size of a capital imparts flexibility to a bank / FI to withstand shock
and thus an entity with higher absolute capital is viewed favorably.
I.2 Quality of Capital (Tier-I Capital):
The proportion of Tier I capital or core capital of a bank /FI is the primary
indicator of the quality of capital .The level of Tier-I capital is given primary
importance when assigning rating for capital adequacy .Although the presence of
Tier-II capital does provide some cushion in the short to the medium term , the
Tier-II capital needs to be periodically replenished .It also analyses other issues
like the presence of hidden reserve and the percentage of the investment portfolio
marked to the market. These issues help in streamlining accounting policy
differential across various entities and have a bearing on the quality of capital.
I.3 Flexibility to raise Tier I capital:
An entity has the flexibility to raise Tier I capital either through internal accruals
or through the capital markets. The ability of the entity to access the capital market
to meet its Tier I capital needs and its ability to service the increased capital base is
considered while evaluating the flexibility of a bank /FI to support the increased asset
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base through earning is an important parameters in assessing sustainability of
capital adequacy .An entity which is able to sustain asset growth through internal
generation without impairing capital adequacy is viewed favorably.
I.4 Growth Plans:
Its factors the future growth plans of a bank/ Fi while analyzing capital adequacy
.The capital adequacy of the entity (although at currently high levels) would be
regarded as unsustainable , if it pursuing a strategy of high growth .
II Resource raising ability:
It analyses the resource position of the bank /FI in terms of its ability to maintain a low
cost , stable resource base .In the domestic context , the resource (funding) composition of
bank and FIs is very different .Bank are significantly deposit funded where as the FIs have
to depend on wholesale funds .
Although some FIs do raise retail funds, they are at a natural disadvantage (in raising retail
deposits) as compared to the banking sector in terms of the restrictions on the minimum
tenure and interest rates, the absence of a cheque issuing facility and a relatively smaller
branch network. Some of the FIs do have access to significant concessional funding from
the government if they are playing a role which is of policy importance t the country.
However, in general the dependence on wholesale funding attaches a degree of risk t the
funding profile of FIs.These risks (especially stability of resource) are partly mitigated by
the access that the all India Financial Institutions (AIFIs) have to funds from provident
funds and insurance sectors; these funds are of a retail origin .Given this basic distinction in
funding profiles between bank/FIs, the funding risk profile of bank / FIs is discussed
separately.
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The following issues are considered while analyzing the resources position of a bank.
II.1 Size of a deposit base:
A large deposit base provides stability to the resource position of a bank. The size
of a deposit base provides the bank, a critical mass for effectively managing its
cash flows and adds considerably to the diversity (in term of the number of
deposits) of the deposit base.
Diversity in the deposit base & in term of large numbers of small ticket size
deposit, the geographically spread and the optimal rural /urban mix, lend stability
to the resources position of a bank. The number of branches and their
geographical spread lend diversity to the deposit base of a bank. Thus a bank with
large number of branches, dispersed all over India and an optimal rural / urban
mix is viewed favorably.
II.2 Deposit Mix:
The deposit mix of a bank has an impact on the cost of deposits. A high
proportion of saving and current deposit, signify a well entrenched deposit base
and lead to a stable and low cost resource base. It also analyses the trends in
deposit mix to form an opinion on the future stability and costs.
II.3 Growth in deposit:
Accretion to deposit is the main source of funding asset growth, and managing
liquidity risk in bank .It compares the growth in deposit of a bank with industry
trends to make relative judgements.
II.4 Cost of deposit:
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Cost of deposit is a function of deposit mix of the bank, its region of operation
and the bank to attract deposit at lower rates. Bank which have a low cost of
resources, not only benefits through higher profitability but also have a higher
flexibility to maintain their resources position, in the face of increasing
competition. The relevant issues while analyzing the resources position of a FIs:
II.5 Diversity of investor base:
Given the fact that the FIs are predominantly wholesale funded, the diversity of
the investor population (both domestic and international) does mitigate the risk
profile to a certain extent .FIs which is dependent on a few investors are viewed
less favorably.
II.6 Funding mix and cost of funds:
Traditionally, all the FIs enjoyed concessional funding from the government in
the form of SLR bonds. This facility has been progressively withdrawn from the
institutions and they have been increasingly accessing market borrowing over the
past few years.The mix of funds between the government and market borrowing
over the past few years. The mix of the funds between the government and market
borrowed funds is an important determinant of the overall cost of funds for an FI.
FIS which still carry a significant proportion of concessional funds on their books
will tend to enjoy a cost of funds advantage in the near terms.
The funding mix between domestic and foreign currency funding is also
examined to determine the overall risk profile .FIs which tend to have a higher
proportion of a foreign currency borrower defaulting on payment obligation and
thus exposing the FI to currency risk.
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This risk assumes significance in the current context, when the economy is
slowing down and there is a greater instance of corporate defaults. In case of FIs
which have been significantly dependent on foreign currency multilateral funds,
the recently imposed economic sanction would affect their resource raising
capabilities.
II.7 Retail Penetration:
Some of the leading FIs have started tapping the retail market for bonds and
deposits. These funds do impart stability to the funding mix and the trends in
raising retail resource are factored favorably into its risk evaluation
III ASSET Quality:
Asset quality of bank/FIs is a measure of the ability of the bank to mange credit risks.
Its analyses the asset quality on the basis of the following parameters:
Geographical diversity and diversity across industries:
Geographical diversity of an asset base and diversity across industries, along with single
risk concentration limits are important inputs in determining the asset quality of bank/FIs.
Industrial development of the states in the western region, like Maharashtra and Gujarat
is relatively higher. Thus, the amount of credit extended in this region is higher
concentration of advances in the western region .However , the bank /FIs with all India
presence have the additional flexibility due to their widespread branch network , to enhance
their exposure to other region , in case of adverse economic development in these states
.However , the regional banks with limited operation and branch network have lesser
flexibility to diversify their advances portfolio and are thus susceptible t adverse economic
condition in a particular region.
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Diversity across industries is largely a function of the geographical presence of the
Bank/FIs and Management policy. The industry exposure and single risk concentration is
monitored by the central bank through exposure guidelines. However, some bank/FIs show
a high degree of exposure t certain industries thus making themselves vulnerable to
downturns in those industries.
III.1 Client Profile of the corporate asset portfolio:
Credit quality of the corporate portfolio of the bank is an important input in the
analysis of the asset quality .It analyses the profile of the client in the asset
portfolio to make a judgement on portfolio quality. The ability of bank/FIs to
attracts better credit quality, especially after the dismantling of consortium
lending. The size (of capital) of a financial sector entity lends considerable
flexibility to the entity to attract larger and better quality clients given its sheer
ability to take on larger exposure in its balance sheet. Also, the ability of the
entities to attract and retain good quality clients by providing value added service
would enhance asset quality in the future.
III.2 Quality of Non-industrial lending:
Bank in India have an obligation to lend a proportion of their funds to the priority
Sector which primarily encompasses agriculture and small scale industries. To
this extent, FIs are better placed than banks because they do not have any such
obligation. It analyses the credit quality of this non-industrial portfolio in arriving
at a judgement on an overall asset quality of a bank. The credit quality of the asset
portfolio is also indicated by the segment wise NPA levels of the portfolio,
indicates the performance of the bank in each segment. This help in gauging the
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relative strength of the bank in each of the loan segment. Some of the banks have
a higher level of exposure to the trading. These advances provide a comparatively
higher yield and also provide diversity due to their small ticket size. The Indian
banks have to compulsorily lend 40% of their total advances to the priority sector.
The break up of the loan within these sectors in an important indicator of the
quality of the portfolio .E.g. An agricultural loan in an agriculturally prosperous
state of Punjab would have a better probability of being repaid as compared to
other agriculturally weak states.
Retail consumers loans (primarily vehicle and housing loans) still do not
constitute a major portion of the asset profile of bank/FIs. However, some large
bank/FI is strategizing towards a universal bank strategy and proposes to expand
significantly in this segment. It looks at the quality of retail consumers credit
growth and its final analysis.
III.3 NPA LEVEL:
The asset quality of a bank depends not only on the credit quality of its but also
on the ability of the bank to manage its asset portfolio. The NPA figures at gross
and net levels help in benchmarking the bank/Fish ability to manage their
portfolio, on a relative scale. While the gross NPA levels are an indicator of the
inherent quality of the asset portfolio of the entity and thus the credit appraisal
capabilities, the net NPA levels are an indicator of the balance sheet strength of
the bank, The NPA levels also indicate the proportion of earning asset of the bank
and the potential credit loss of bank. The proportion of earning asset and the
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potential credit loss would have a bearing on the future earning capability of the
bank.
Movement of provision and write offs:
Some bank/FIs follow a practice of their bad loans, in large portion of their bad
loans, in order to clean up their balance sheets.
Thus the present NPA numbers are not a true indicator of the banks asset
portfolio .Hence, NPA levels alone, cannot be criteria to assess future asset quality
of the bank. Average provisioning including write-offs, over a five years time frame is
an indicator of the levels cleaning up done by the bank, over the years, in order to
reduce its NPA levels. The amount of provisioning done is also an indicator of the
inherent credit quality of the asset portfolio. The average provisioning levels and its
movement serve as indicators of the credit risk of the portfolio and the expected
future write-offs and provisioning which would further affect the earning capability
of a bank.
III.4 Growth in advance:
High growth rates in the financial sector bring the establishment of collection
systems, tracking of asset quality and low seasoning of the lending portfolio. It
closely analyses the pattern and nature of growth .It studies the entities with
higher growth rates more carefully to look at the nature of growth, reason growth
and its implications on the asset quality. An entity which has grown by attracting
good quality clients from its competitors would be viewed more favorably as
compared to one which has grown by attracting good quality clients from its
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competitors would be viewed more favorably as compared to one which has
grown just by increasing its geographical presence or diluting credit criteria.
IV Management and system evaluation:
It believes that the quality of management can be an important differentiating factor in the
future performance of the bank/FI. The analysis of the management is carried out on the
following parameters.
IV.1Goals & strategies:
The future goals and strategies of the bank are evaluated to take a view in the
vision of the bank management. The ability of bank to adapt to the changing
environment and their ability to mange credit and market risk , especially in a
scenario of increasing deregulation of the financial market assumes critical
importance.
IV.2 System & monitoring:
It studies the credit appraisal system for managing and controlling credit and
market risk at a portfolio levels. Significant emphasis is laid on the risk
monitoring system and the periodically and quality of such monitoring. Most
Indian banks face the challenges of enhancing their information system and quality
of information reporting. The degree of acceptance of new system and procedure in
the bank, data monitoring systems and the extent of computerization within the
bank is given significant importance .The level of computerization is gauged on the
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basis of the extent of the business covered by computerization, the computerization in
branches and computerization of money market and forex market desks.
It attaches significance to the operating system for data capture and MIS reporting
in a bank .A bank balance sheet with a large volume of operating system in the
bank, and is viewed negatively.
IV.3Appetite for risk:
A high risk propensity of a management , typically reflect in the higher volatility
in earning in both fund based as well as non- fund based business .A management
with a higher propensity to take risk is viewed cautiously.
IV.4 Motivation level of staff:
The motivational level of employees would direct affect the service level of the
bank which is a key success factor in a market driven environment.
V Earning Potential:
It analyses on the following basis of the level
V.1 Level of earning:
It is measured by return on total asset provides the cushion for its debt service,
and also increases the ability of the bank to cover its asset risk. The ROTA is a
function of interest spread, expenses levels provisioning levels and the non- interest
income earned by the bank.
The size of net profit is also factored while rating of the entity. Earning of the
bank /FIs has been affected due to the volatility in interest rates. Thus, the trend
in profitability at gross profit levels is examined over the past levels is examined
over the past years to take a view on the sustainability of earning. The various
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elements leading to the profitability like net interest income, non-interest income ,
expense levels and the provisioning levels are also analyzed to take and the
sustainability of profits in future.
V.2 Diversity of income sources:
It is an important input in analyzing the stability of earning. Diversity of income
sources between various categories of funds based income like industrial portfolio
, retail portfolio, etc. lends stability to the income streams through non-interest
income like guarantees, service charges from its retail customer, trading income,
etc. The non-interest income provides cushion to the profitability, especially
which have the capability to provide better value added service would be in a
better placed to improve their fee based income. A closer analysis the
composition of the revenue streams, help in taking a view regarding the
sustainability of the earning.
VI Liquidity/Asset Liability Management:
It assesses the liability maturity profile of the entity to form an opinion on the liquidity risk
as well the interest rate risk.
VI.1 Liquidity risk:
It factors the resources strength of the bank in form of access to call borrowing
and the extent of refinance available from RBI. The bank are the primary channel
through which retail saving are channeled back into the public sector bank having
a wide spread branch network act as conduits for mobilization of retail saving . It
views most of the public sector bank favorably on the liquidity support available
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to the liquidity support available to the bank in the form of call money and RBI
refinance.
VI.2 Interest rate Risk:
The rating factor the volatility of the bank /FIs earning to interest rate changes .It
analyses the asset liability maturity profile of an entity to judge the level of interest
rate risk carried by the entity. In the Indian banking system, the interest rate and
maturity profile of the asset and liabilities have an inherent mismatch. the floating rate
advances portfolio (linked to prime lending rates ) and the relatively long duration
investment portfolio are funded through short to medium tenure liabilities which
exposes the bank to an element of interest rate risk.
FIs do score over bank in this regard due to the whole sale nature of their
operation and policies which link the nature of their operation and policies which
link the nature of borrowing (fixed/ floating ) with corresponding matched lending
.On an overall basis , FIs carry relatively lesser interest rate risk as compared to
the bank.
Parent support:
It factors the parentage of the entity in the final rating decision .The extent of support
factored is a function of the relative size of the two entities, the credit quality of the parent
and the strategic importance of the subsidiary to the parent .It positively factors the system
support for specialized entities in the financial sector, which have a policy role in the
national economy.
5. Draft report:
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Following the meeting with its management and subsequent analysis of the data obtained,
the analysts draft a rating report on the bank. Depending on the rating agreement and the
particular circumstances, this may be a short-form report (one page of text forming the
rating report, plus spread sheets) or a long-form report (one front page of text forming the
rating report, plus ca. five pages of text providing our rating analysis, plus spread sheets,
plus spread sheet annex, providing explanatory notes to the spread sheets). The analysis in
the text of the long-form report is arranged under main and sub- headings which tie in with
the topics covered in the bank questionnaire.
6. Presentation of draft report to bank
We send our draft report (without ratings) to the bank being rated, for two reasons:
- so that its factual accuracy may be checked;
- to allow management to determine whether we have included any information in our draft
which was given in confidence and which should be excluded on these grounds.
7. Amendment and subsequent circulation of report to rating
committee; composition of the committee
We amend our report in accordance with any comments from the bank which meet the
criteria in 6., above, and circulate it together with other, relevant documentation among the
members of a rating committee, which normally has a complement of five.There is no
single, standing rating committee; rather there is a committee for ach country we cover, or,
in some cases, for each peer group of banks in each country. The two analysts who visited
the bank, did the analysis and wrote the report are always members of its rating committee.
8. Rating committee meeting; assignment of ratings
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At the rating committee meeting the two analysts responsible for the work done so far
present the rest of the committee with the report they drafted, which has since been seen by
the bank and possibly amended, as explained above, to accord with its comments. They
also present relevant confidential data, which they have not been able to include in the
report, and peer group analyses comparing the bank with its domestic and foreign peers.
The ratings implied by the formula are not treated as definitive: they are considered only as
further input to the rating decision so that there remains a strong subjective element in our
final judgements - a subjectivity tempered, we trust, by several years experience (allowing
a reasoned extrapolation of the future), by common sense and by specialized knowledge
and research.
9. Dissemination (or non-dissemination) of the ratings
When a bank being rated for the first time has been informed of the decision of the rating
committee, it has no recourse to an appeal, but it does have the right to decide whether it
wishes our ratings to be made public and the rating report to be sent to our subscribers.
However, normally before launching ourselves into the work involved in a new rating,
which possibly also involves coverage of a country which is new to us, we would have
tried to provide the entity being rated with an "indicative" rating. That is to say, on the
basis of a brief analysis of the data available to us we would provide a range of likely
ratings within our rating scales so that the bank being rated has from the start an
approximate idea of what its ratings will be. In the event that the bank does accept that
publication should take place, then the rating report and the ratings will be dispatched to
our subscribers who include over 1,200 major institutions worldwide. In addition, our
ratings will be made available to the public by means of the "wire" services, press releases,
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etc. If the bank does not want the ratings published and the report disseminated, then the
project will be terminated, and regular subscribers will not be informed that we have done
rating work on the bank concerned.
CASE REPORTCASE REPORTCase I
The Federal Bank Limited
National
Subordinate Debt A+(ind)Rating Outlook Stable
Foreign Currency
Short-term Senior -Long-term Senior -Long-term Rating Outlook -
International
IndividualSupport 5T
Sovereign Risk
National AAAForeign Currency Long-term BBSeniorLocal Currency Long-term BB+
SeniorFinancial Data
The Federal Bank Limited
31/03/2002 31/03/2001
Total Assets [US$ mn] 2,104.7 1,891.1Total Assets [INR mn] 101,446.1 88,200.4
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Equity [INR mn] 4,487.9 4,154.7 Net Income [INR mn] 820.1 610.4ROA [%] 0.86 0.74ROE [%] 18.98 15.70Equity/Assets [%] 4.42 4.71
Rating Rationale
Assessment
The ratings of The Federal Bank Limited (FBL) reflect its relatively small size, average
financial profile and long operating history. With a large proportion of its branches and
business concentrated in its home state of Kerala, the Bank enjoys a strong franchise
among depositors in the state and the expatriate Keralite community. FBLs pursuit of
rapid loan and asset growth since the mid-1990s (its loan book has grown by over three
times since FY95) without commensurate credit appraisal and risk management systems,
coupled with a slowdown in the economy has resulted in a deterioration of its asset quality.
Gross and net NPLs as a proportion of gross and net advances have risen over the years and
were at 11.82% and 7.36% for end-September 2002. FBLs loan loss reserve coverage
improved to 40% at end-September 2002 from 29.2% at end-FY02. Its net NPLs to equity
ratio, although improved, was still high (at over 77%) in comparison to some of its peer
banks. Although FBLs total capital ratio of 10.63% (Tier 1 ratio was 6.96%) at end-
March 2002 was above the regulatory minimum of 9%, its low capital base is reflected in
its low equity to asset ratio of 4.42%, emphasising the need to bolster the Banks equity
base, especially Tier 1, to enable it to better absorb the present and future asset quality
shocks and support its planned asset growth. Of FBLs total deposits, NRI deposits form a
substantial proportion and these, along with the term deposits, render its funding base
stable, but expensive. The Bank is focussing on reducing its funding costs by increasing the
share of lowcost savings and current deposits by enhancing its reach through an increased
branch and ATM network. As against the general industry trend, FBLs net interest
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margins have improved in the last couple of years on the back of declining average funding
costs and higher average yields from its retail loan portfolio. Net Interest Margin (NIM) at
3.1% was better than its peer group banks. Backed by higher operating income, FBLs
cost-to-income ratio improved to 38.5% for end-FY02 from 56.7% in FY00. With its
loan-to-deposit ratio consistently above 55%, FBLs reported liquidity ratios were low.
FBL reported some mismatches in its asset-liability maturity in the short term, although
these are mitigated by high deposit renewal rates.
Support
FBL has no identifiable controlling shareholder, and while its existing shareholders are
likely to be willing or able to provide support to the Bank as a going concern, it is less
clear whether they will be willing or able to provide resources in an extreme situation.
Although RBI has a good track record of supporting banks in times of need, FBL is a
small player in the banking system. In our opinion, therefore, support is possible, should
that be necessary, but it cannot be relied upon. The 'T' suffix to our Support rating indicates
certain subinvestment grade features of the Indian economy that could limit support for
foreign currency creditors.
Background
The Federal Bank Limited was established in 1931 as the Travancore Federal Bank Ltd..
The Bank was listed on local bourses after its initial public offering in 1994. The ICICI
group is the single largest shareholder, with 21.35% of the Banks equity, while public
holding was 61.72% as at end-June 2002. FBL primarily lends to mid-size corporates,
small and medium enterprises and individuals, and is now focussing on highly rated large
and medium corporates and the retail sector.
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PROFILE
An old private sector bank; operates as a regional bank with high concentration of
business in its home state of Kerala.
Focus shifting from corporate to retail banking.
Established as a private sector bank at Nedupuram in the southern state of Kerala by a
small group of local citizens, The Federal Bank Limited changed its headquarters to
Alwaye in 1945. The Bank was established to cater to the banking needs of traders and
agriculturists. Over time, as a large proportion of the local population migrated to other
countries, especially the Middle East, FBL also catered to the local banking needs of these
expatriates. In the 1960s, the Bank took over five other small banks and became a
scheduled commercial bank in 1970. FBL was listed on domestic bourses after its initial
public offering in 1994, and in 1996 held a successful rights issue. Prior to its IPO the Bank
had privately placed equity with the IC ICI group, which continues to be the single largest
shareholder. The shareholding pattern as on June 30, 2002 is given in
Table 1: Shareholding Pattern of FBL
Category % of
ICICI Group 21.35
Mutual Funds and Unit Trust of India 4.82
Foreign Institutional Investors 1.50
Banks, FIs, NRIs and OCBs 2.11
Individual Public Shareholders 61.72
Source: The Federal Bank Limited, Fitch
Apart from providing its customers with traditional retail and commercial services, FBL
has an active treasury. In FY2000, the Bank decided to cease the operations of its wholly
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owned subsidiary Fedbank Financial Services Limited that was engaged in the business
of hire purchase, leasing and merchant banking due to an unfavourable environment
affecting non-banking finance companies in general, and the company now exists only as a
shell company with a core capital of INR5 million. FBL has links with 13 exchange houses
and seven banks in the Middle East for providing foreign currency remittance facilities to
its customers, especially in the Middle East. The Bank has an agreement with ICICI
Prudential Life Insurance to undertake distribution of life insurance products. FBL also
offers Depository Services to its customers. FBL has the largest branch networks amongst
the old private sector banks. As of March 31, 2002, the
Bank serviced it customers through 416 branches and 62 ATMs. 73% of the Banks
branches are located in its home state of Kerala, and given the high concentration of its
business in the state, FBL can be viewed as a regional player in the banking sector. The
Bank plans to increase both its branch and ATM network to 500 each by FY06. FBL had
appointed Accenture, an international management consulting group, to conduct an
organisational restructuring study for the Bank. The consultants have submitted their report
and recommendations and the Bank is now working on implementation of these.
Technology: FBL has automated all of its branches using its in-house banking software
FedSoft. At present, 74 of its branches are interconnected through leased lines with plans
to switch to a Wide Area Network (WAN). The Bank already offers Internet banking under
the brand name FedNet in addition to mobile and telephone banking. FBL has invested
INR650m in its IT initiatives and plans to invest an additional INR 1 billion over the next
three years for interconnecting its branches, expanding its ATM network, extending its
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current mobile and telephone banking capabilities and to migrate to a centralised banking
solution from the current hub and spoke set-up.
PERFORMANCE
Weak, but improving, asset quality requiring higher loan loss provisions have
constrained FBLs profitability.
Improving net interest margins despite high funding costs and declining yields on
loans and investments.
Post liberalisation in the early 1990s, FBL pursued aggressive loan and asset book
expansion, but faced asset quality problems on account of prolonged economic slowdown
and its own weak credit appraisal and monitoring systems, requiring increased loan loss
provisions. This, coupled with declining interest rates amidst intensifying competition, has
adversely impacted the Banks performance. ROA and ROE, which were at 1.3% and
30.73%, respectively, in FY95, have since declined to 0.86% and 18.98%, respectively, in
FY02.
Net Interest Revenue: Net interest income (NII) continues to the predominant source of
revenue for FBL, although its share in total operating income has declined to 55.6% in
FY02 compared to 68.75% in FY95. After recording a sharp decline in its NII in FY99 on
account of a steep rise in its interest expenses, the Banks NII has grown nearly three times
since then. NII growth at 16.6% in FY02 continued to be healthy, though it was below the
34.5% growth recorded in FY01. Interest expenses, which had declined during FY01 and
FY00, grew by over 12% during FY02 on the back of substantial deposit growth in last two
years, which explains the lower NII growth rate.
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As against the general industry trend,
substantial decline in its NII), and its
NIM at 3.1% FBLs net interest
margins (NIM) have improved after
recording a sharp decline in FY99
(which was due to for FY02 was better
compared to its peers old private
sector banks as well as some of the
better- performing government banks. Although declining, FBLs average funding costs
at 8.9% for FY02 continued to be high, and the bank is focussing on reducing this further
by cutting the interest rates on its high cost foreign currency NRI deposits and increasing
the share of low cost retail deposits by enhancing its delivery capabilities.
Non-interest Income: FBLs non-interest incomes are primarily derived from its treasury
money market and foreign exchange and trade finance related activities. The share of
non-interest income a fivefold increase in its profits from sale of in total operating income,
which had been declining since FY99, grew to 44.4% in FY02 primarily due to
investments, mainly Government securities (G- Secs). In the last couple of years, most
Indian banks have built up government securities investments in excess of reserve
requirements as there has been a dearth of quality lending opportunities and the
declining interest rates provided increased arbitrage opportunities on these investments.
Profits from trading in G-Secs have continued in H1 FY03, and annual profits in 2003 from
this business are projected at the same level as FY02.
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FBLs total non-interest income grew
by over 76% in 0 FY02 compared to a
contraction of 5.4% in the previous
year. While the growth was fuelled by
a 560% rise in its income from G-Sec
trading, its other non-interest incomes
declined during FY02. A high
proportion of treasury income adds an
element of volatility to the Banks revenue profile, and it has entered into a number of
areas, including cash management services and distribution of third-party insurance, to
augment its non-interest income, in an attempt to ensure a more stable revenue profile and
maintain its profitability levels.
Operating Expenses: The large infrastructure maintained by Indian banks in terms of
branches and employees renders
their operating expenses high. FBLs
non-interest expenses have grown by
over two and a half times since FY95
on account of higher employee costs
on the back of two wage revisions
during the period. However, its cost-
to-income ratio has improved to
38.52% for FY02 compared to a high of 75.45% in FY99. Employee costs continue to be
the major contributor, accounting for over 63% of total operating expenses and 1.36% of
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average earning assets. Going forward, FBLs operating expenses are expected to rise
further in view of the on-going expansion of its branch and ATM network as well as
technology related and other operating and marketing expenses. However, given the
improving operating income levels, the cost-to-income ratio is not expected to rise
significantly.
Loan Loss Provisions: The rapid expansion to the banks loan book since the mid-1990s
(loans and advances grew by over
three times since FY95), coupled with
the pronounced slowdown in the
Indian economy and progressively
tightening prudential norms, have
adversely impacted FBLs asset
quality necessitating higher loan loss
provisions in recent years. While
FBLs total loan loss provisions grew by 54% in FY02, these have grown by over four
times since FY98. Loan loss provisions formed 51% of total pre-provision operating profits
for FY02. As a proportion of average loans these have grown to 3.1% for FY02 from
0.96% in FY99. FBLs loan loss provisions are expected to remain high in the medium
term, in view of its high level of NPLs amidst a weak macro-economic environment,
implementation of the 90-day default norm that takes effect from 31 March 2004 and the
building up of loan loss coverage by the Bank.
Half-Year Performance: As per the audited (limited review) results for the half-year
ended September 30, 2002 (H1 FY03), FBLs net income (profit after tax) grew by 1.9%
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and was supported by 11.9% growth in NII. Operating profits growth at 5% was
constrained by a 9.4% increase in total non-interest expenses during H1 FY03. Provisions
including loan loss provisions were higher by 3%. For FY03, FBL has projected higher
operating profits on account of improved net interest income (NII), while lower provisions
are projected to result in substantially higher net incomes (profit after tax).
Prospects: FBLs performance, to a large extent, is dependant on the economy of its home
state Kerala and its NRI deposits base. Saddled with a high level of NPLs, the Bank is
currently focusing on cleansing its balance sheet by reducing its NPLs, further
strengthening its credit risk measurement and management systems, reducing reliance on
costly NRI deposits and increasing the low cost retail deposits to reduce its funding costs.
In the short to medium-term, FBL is expected to benefit from higher treasury income and
its sustained recovery efforts resulting in improved asset quality. Given the intensifying
competition, amidst a generally declining interest rate environment, the Bank will be
required to develop its fee-based incomes for a more balanced revenue profile. Over the
long-term, we expect FBL to emerge a stronger player with a solid deposit franchise in
Kerala and a geographically diversified asset book.
RISK MANAGEMENT
Aggressive loan book growth and relatively weak credit appraisal and
monitoring in mid-1990s have resulted in weak asset quality.
FBL has been strengthening its risk management systems.
FBLs Board of Directors is responsible for setting up the Banks risk management policies
and has put in place the Risk Management Committee to implement policies and
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procedures to identify, monitor and manage risks including credit, market, liquidity and
operational risks. The Credit Risk Management Committee (CRMC), reporting to the
Chairman, measures and monitors the credit risk of the Banks loan portfolio, while the
Asset Liability Committee (ALCO) measures and monitors market and liquidity risks and
uses Earnings at Risk (EaR) for measuring the risk of its trading and banking
book. Recently, the Bank has also set up the Operational Risk Committee (ORCO) to
measure and monitor operational risks arising from the failure of people, processes,
products, technology, etc. Going ahead, the Bank is strengthening its risk management
systems through increased use of technology, training its staff in risk measurement and
management and prescribing stringent appraisal and monitoring norms for the risks faced
by FBL.
Credit Risk: FBL lends to corporates and small and medium-sized enterprises (SMEs) for
their working capital requirements and
trade financing. Large credits (greater
than INR50m) and lending to the SME
sector collectively accounted for over
80% of the Banks total loan book,
while retail and other loans made up
the balance. In FY02, growth in
FBLs loan book at 6.9% was lower
compared to FY01s 20.3%. Over 80% of the Banks loans are secured by collateral,
including inventory, receivables, land or plant and machinery. Additional security by way
of shares, as well as corporate or personal guarantees is obtained, wherever necessary.
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FBLs top four exposures to the industrial sector were to textiles (11.59%), food processing
(10.4%), iron & steel (9.8%) and real estate 8.4%.
FBL follows a credit rating model for all its credit exposures above INR50m, where they
are classified into 10 categories of risk grades from FB-1 to FB-10 (FB-1 being the best
and FB-10 being the worst). Borrowers are evaluated on various business an does not
qualify for assistance. The loan booked financial parameters and assigned a credit rating,
and any proposal failing to attain at least a FB-6 rating composition as per the Banks
credit ratings for end-FY02 is given in Table 2.
.Table 2: Loan Book Composition by Credit Ratings
(%) FB-1 FB-2 FB-3 FB-4 FB-5 FB-6 D
2.03 17.88 29.38 19.94 5.94 0.0 24.81
By end-FY03, FBL intends to assign credit ratings to all loans above INR200, 000, with
plans to review the ratings every six months, instead of the annual basis currently followed.
The Bank has been linking the pricing of its loans to its self-defined credit rating;
however, it maintains some flexibility in pricing, especially for top-rated credit accounts,
given the intense competition in this segment.
Loan Loss Reserves: FBL follows the RBI norms for classifying NPLs and providing for
loan losses, and these are somewhat liberal by international standards. A loan is classified
as an NPL when interest and/or principal are outstanding for 180 days. FBLs lending to
the real estate sector accounted for nearly 9.3% of the total gross NPLs as of end-FY02.
This was followed by loans to the iron & steel sector (5.5%) and non-banking finance
companies (3%).
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(INRm/%) FY 02 FY 01 FY 00 FY 99
Gross NPLs 6,380 6,420 4,900 4,790As % of Gross Loans 11.88 12.84 11.75 10.93
Loan Loss Reserves (LLR) 1,864.4 1486.0 1,389.9 1,562.9
LLR to NPLs (%) 29.21 23.14 28.34 32.61
Net NPLs to Equity (%) 99.34 117.78 95.31 98.61
Net NPLs to Net Loans (%) 8.60 10.08 8.56 7.53
Grading of Net NPLs (%)
Sub-standard 52.41 63.16 - -
Small-Doubtful 47.53 47.53 36.84 - -
Bad debts 0.0 0.0
Table 3: Trends in FBLs Asset Quality
FBL pursued aggressive loan book expansion in the mid-1990s, which was followed by a
prolonged economic slowdown, tightening asset classification and provisioning norms.
Due to FBLs relatively weak credit appraisal and monitoring mechanisms, this led
to a substantial deterioration in its asset quality. Both gross and net NPLs have grown in
absolute terms as well as a proportion of gross and net advances.Reported gross and net
NPLs as a ratio of gross and net advances, at 11.88% and 8.6% respectively, for end-FY02,
continued to be high. Application of the 90-day default norm, to be effective from March
31, 2004, would result in gross NPLs rising to over 17% of gross advances as at end-FY02.
However, under the RBIs monitor able action plan on FBL, the Bank has given an
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undertaking to bring its net NPL ratio below 7% by end-March, 2003. Net NPLs were
already down to 7.36% as of September 30, 2002. FBLs NPL composition deteriorated in
FY02 as doubtful assets as a proportion of total net NPLs increased to over 47% compared
to 37% in FY01 the previous fiscal primarily due to ageing of sub-standard assets, and
while this somewhat adds to our asset quality concerns, FBL has been able to contain fresh
accretion of NPLs in recent times. FBLs loan loss provisions had failed to keep pace with
the deterioration in its asset quality and this is reflected in its low loan loss reserve
coverage ratio, which stood at only 29.2% for end-FY02 from a high of 32.6% in FY99.
However, the coverage improved to 40% for end-September 2002 on the back of increased
provisioning, and if the technical write-offs are added back, the coverage improves further
to 57.4% as at end-September 2002. FBL plans to further reduce its NPL levels through
aggressive recovery efforts and increased loan loss provisioning. FBLs net NPLs to equity
ratio improved to 77.6% for end-September 2002 from 99.34% for end-FY02 and is
expected to improve further to about 56% by end-FY03.
Market Risk: As for most Indian banks, FBL is exposed to interest rate and liquidity risks
on account of a structural maturity mismatch arising from funding the loan and fixed-
income investment portfolio through short-term customer deposits. To a large extent these
risks are mitigated by high renewal rates and relatively stable nature of the Banks deposits
and because the bulk of the Banks loans are contracted on a floating rate basis. Even on
fixed-rate loans, the Bank reserves the right to re-price them periodically. In addition, the
Banks holds government securities in excess of reserve requirements and the portfolio has
witnessed appreciation in value on account of falling interest rates.
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FUNDING AND CAPITAL
Customer deposits, especially NRI deposits, have funded FBLs growth.
Low capitalisation levels; capital ratios under pressure due to expanding asset base
and high level of NPLs.
Funding and Liquidity: FBL, like most Indian banks, is predominantly funded through
customer deposits and these accounted for 91.7% of total deposits and money market
funding as of end-March 2002. However, the deposit mix has historically been skewed
towards relatively stable but costlier term-deposits, especially the foreign currency term
deposits on account of expatriation by non-resident Indians (NRI). These NRI deposits
form approximately 45% of the total deposit base, and nearly 61% of total deposits from
branches in the state of Kerala are NRI deposits. FBL plans to reduce its funding costs
through a two-pronged strategy. Firstly, the Bank intends to phase out the premium it pays
on its NRI Deposits, and secondly, it plans to increase the share of low-cost retail savings
and demand deposits through enhanced delivery capabilities in form of expanding branch,
ATM and Internet banking network and improvised retail liability products. Presently, the
bank reports high renewal rates of its term-deposits and the accretion to deposits has
consistently exceeded the repayments. Historically, FBLs credit to deposit ratio has been
relatively high at above 55%, and consequently its liquidity ratios have been somewhat
lower. While loans as a proportion to deposits and money market funding declined to
56.2% for end-FY02 compared to 60.6% in the previous year, these were still high
compared with most other banks, while its quasi-liquid assets (deposits with banks and G-
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Secs) comprised 33.1% of the Banks total assets. As FBLs is expected to continue
expanding its loan book in the medium-term, its liquidity ratios are expected to remain low
in the near future. The maturity profile of FBLs assets and liabilities as on March 31, 2002
over the next five years is shown in Table 4. FBL reports negative gaps in some of the time
buckets up to one year and in the one-to-three year time bucket. As most of these negative
gaps are on account of maturing customer deposits and given the fact that the Bank reports
a high renewal rate in case of term deposits (58% in case of domestic term deposits and
62% for NRI deposits) and high retention in savings and demand deposits, Fitch is of the
opinion that liquidity risk is substantially mitigated.
Capital: Continued growth in FBLs asset base coupled with tightening prudential norms
in recent years has led to decline in its capital adequacy ratio. FBLs reported total capital
adequacy ratio at 10.63% for end-FY02 was slightly above the regulatory minimum of 9%,
although its Tier 1 ratio at 6.96% was low, and in the absence of any fresh equity
raising, the Tier 1 ratio has hovered between 7% and 8% for the last four years. Further,
like most Indian banks, FBLs capital adequacy ratios are partly boosted by its holding of
low-risk G-Secs that accounted for nearly 26% of its total assets as of end-FY02.
Table 5: Trends in FBLs Capital Ratio
(%) FY 02 FY 01 FY 00 FY 99
Tier 1 6.96 7.72 7.72 6.48Tier 2 3.67 2.57 3.61 3.84Total 10.63 10.29 11.33 10.32
Equity/Asset 4.42 4.71 4.76 4.00
In the past decade, FBL enhanced its equity base on two occasions first in 1994 through
its initial public offering, and then in 1996 through a rights issue; since then its capital
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ratios have been supported by internal accretions and subordinated debt issuances. FBLs
capital ratios are expected to come under pressure as the Bank continues to expand and
addresses its asset quality problems through higher provisioning and write-offs over the
next few years. The low equity levels are also reflected by the Banks low equity to asset
ratio that has ranged between 4% and 5% and stood at 4.42% at end-FY02. This
emphasizes the need for the Bank to bolster its Tier 1equity levels going forward.
BALANCE SHEET ANALYSISThe Federal
Bank Limited
31
Mar
ch
31
March
2002
As
%
Of
of
Aver
age
31
Mar
ch
As
%
Of
31
March
2000
As
%
Of
31
Mar
ch
As
%
Of
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2002
(US
Dm)
(INRm
)
As
set
s
IN
R
m)
(INR
m)
2001
INR
m)
As
set
s
INRm) As
set
s
1999
INR
m)
Ass
ets
A Loans1.GuaranteedbyBanks/Gov
147.1 7,092.3 7.0 7,017.5
6,942.6
7.9 6,215.3 8.2 9,148.9
11.3
2. Secured 864.8 41,683.8
41.1
39,797.5
37,911.3
43.0
32,857.6
43.2
28,569.4
35.4
3. Unsecured 64.6 3,115.1 3.1 3,401.2
3,687.3
4.2 1,284.2 1.7 4,559.4
5.6
4. (Loan LossReserves)
n.a - 0.0 - - -
TOTAL A 1,076.6
51,891.1
51.2
50,216.2
48,541.3
55.0
40,357.1
53.1
42,277.7
52.4
B. OtherEarning Assets
1. Depositswith Banks
125.1 6,027.8 5.9 5,076.5
4,125.1
4.7 4,484.9 5.9 6,631.8
8.2
2. GovernmentSecurities