During the course of its business, a bank may assume exposures on other banks, arising from trade transactions, money placements for liquidity management purposes, hedging, trading and transactional banking services such as clearing and custody, etc. Such transactions entail a credit risk, as defined, and therefore, it is important that a proper credit evaluation of the banks is undertaken. It must cover both the interpretation of the bank's financial statements as well as forming a judgement on non-financial areas such as management, ownership, peer/ market perception and country factors.

The key financial parameters to be evaluated for any bank are:

1. Capital Adequacy

2. Asset Quality

3. Liquidity

4. Profitability

5. Banks will normally have access to information available publicly to assess the credit risk posed by the counter party bank.

Capital Adequacy

Banks with high capital ratios above the regulatory minimum levels, particularly Tier I, will be assigned a high rating whereas the banks with low ratios well below the standards and with low ability to access capital will be at the other end of the spectrum.

Capital adequacy needs to be appropriate to the size and structure of the balance sheet as it represents the buffer to absorb losses during difficult times. Over capitalization can impact overall profitability. Related to the issue of capitalization, is also the ability to raise fresh capital as and when required. Publicly listed banks and state owned banks may be best positioned to raise capital whilst the unlisted private banks or regional banks are dependant entirely on the wealth and/ or credibility of their owners.

The capital adequacy ratio is normally indicated in the published audited accounts. In addition, it will be useful to calculate the Capital to Total Assets ratio which indicates the owners' share in the assets of the business. The ratio of Tier I capital to Total Assets represents the extent to which the bank can absorb a counterparty collapse. Tier I capital is not owed to anyone and is available to cover possible losses. It has no maturity or repayment requirement, and is expected to remain a permanent component of the counter party's capital.

The Basel standards currently require banks to have a capital adequacy ratio of 8% with Tier I ratio not less than 4%. The Reserve Bank of India requirement is 9%. The Basel Committee is planning to introduce the New Capital Accord and these requirements could change the dimension of the capital of banks.

Asset Quality

The asset portfolio in its entirety should be evaluated and should include an assessment of both funded items and off-balance sheet items. Whilst non performing assets and provisioning ratios will reflect the quality of the loan book, high volatility of valuations and earnings will reflect exposure to the capital market and sensitive sectors.

The key ratios to be analysed are

1. Gross NPAs to Gross Advances ratio,

2. Net NPAs to Net Advances ratio

3. Provisions Held to Gross Advances ratio and

4. Provisions Held to Gross NPAs ratio.

Some issues which should be taken cognisance of, and which require further critical examination are:

• where exposure to a particular sector is above a certain level, say, 10% of total assets

• where a significant part of the portfolio is to counter parties based in countries which are considered to be very risky

• where Net NPAs are above a certain level, say, 5% of the loan assets.

• where loan loss provision is less than a certain level, say, 50% of the Gross NPA.

• where high risk/ return lending accounts for the majority of the assets.

• where there are rapid rates of loan growth. (These can be a precursor to reducing asset quality as periods of rapid expansion are often followed by slow downs which make the bank vulnerable.)

• net impact of mark-to-market values of treasury transactions.

Commercial banks are increasingly venturing into investment banking activities where asset considerations additionally focus on the marketability of the assets, as well as the quality of the instruments. Preferably banks should mark-to-market their entire investment portfolio and treat sticky investments as "non-performing", which should also be adequately provided for.

Liquidity

Commercial bank deposits generally have a much shorter contractual maturity than loans, and liquidity management needs to provide a cushion to cover anticipated deposit withdrawals. The key ratios to be analysed are

1. Total Liquid Assets to Total Assets ratio (the higher the ratio the more liquid the bank is),

2. Total Liquid Assets to Total Deposits ratio (this measures the bank's ability to meet withdrawals),

3. Loans to Deposits ratio and

4. Inter-bank deposits to total deposits ratio.

It is necessary to develop an appropriate level of correlation between assets and liabilities. Account should be taken of the extent to which borrowed funds are required to bolster capital and the respective redemption profiles.

Profitability

A consistent year on year growth in profitability is required to provide an acceptable return to shareholders and retain resources to fund future growth. The key ratios to be analysed are:

1. Return on Average Assets (measures a bank's growth/ decline in profits in comparison with its balance sheet expansion/ contraction),

2. Return on Equity (provides an indication of how well the bank is performing for its owners),

3. Net Interest Margin (measures the difference between interest paid and interest earned, and therefore a bank's ability to earn interest income) and

4. Operating Expenses to Net Revenue ratio (the cost/income ratio of the bank).

The degree of reliance upon interest income compared with fees earned, heavy dependency on certain sectors, and the sustainability of income streams are relevant factors to be borne in mind.

The ability of a bank to analyse another bank on the above lines will depend upon the information available publicly and also the strength of disclosures in the financial statements.

In addition to the quantitative indices, other key parameters to be assessed are:

1. Ownership

2. Management ability

3. Peer comparison/ Market perception

4. Country of incorporation/ Regulatory environment

Ownership

The spread and nature of the ownership structure is important, as it impinges on the propensity to induct additional capital. Support from a large body of shareholders is difficult to obtain if the bank's performance is adverse, whilst a smaller shareholder base constrains the ability to garner funds.

Management Ability

Frequent changes in senior management, change in a key figure, and the lack of succession planning need to be viewed with suspicion. Risk management is a key indicator of the management's ability as it is integral to the health of any institution. Risk management should be deeply embedded and respected in the culture of the financial institution.

Peer Comparison/ Market Perception

It is recognized that balance sheets tend to show different structures from one country to another, and from one type of bank to another. Accordingly, it is appropriate to assess a bank's financial statements against those of its comparable peers. Similarly market sentiment is highly important to a bank's ability to maintain an adequate funding base, but is not necessarily reflective of published information. Special notice should be taken where the overall performance of the peer sector, in general, falls below international standards.

Country of Incorporation/ Regulatory Environment

Country risk needs to be evaluated since a bank which is financially strong may not be permitted to meet its commitments in view of the regulatory environment or the financial state of the country in which it is operating in.

Banks should be rated (called Bank Tierings) on the basis of the above factors. An indicative tiering scale is:¹

Facilities

Facilities to banks can be classified into three categories:

1. On balance sheet items such as cash advances, bond holdings and investments,

2. off-balance sheet items which are not subject to market fluctuation risk such as guarantees, acceptances and letters of credit.

3. Facilities which are off-balance sheet and subject to market fluctuation risk such as foreign exchange and derivative products.

Settlement facilities:

These cover risks arising through payment systems or through settlement of treasury and securities transactions.

The tiering system enables a bank to establish internal parameters to help determine acceptable limits of exposure to a particular bank/ banking group. These parameters should be used to determine the maximum level of (a) and (b) above, maximum tenors for term products which may be considered prudent for a bank and settlement limits. Medium term loan facilities and standby facilities should be sanctioned very exceptionally. Standby lines, by their very nature, are likely to be drawn only at a time when the risk in making funds available is generally perceived to be unattractive.

Bank-wise exposure limits should be set taking into account the counter party and country risks. The credit risk management of exposure to banks should be centralised on a bank-wide basis.

¹ The rating scale for bank rating should be in tandem with CRF to synthesize credit risk on account of all activities for the bank as a whole.