GCR's Criteria For Rating Banks

The rating of banking institutions accounts for a significant portion of GCR's business, as GCR rates more banking institutions in Africa than any other rating agency. GCR's expertise in this market is widely recognised and highly regarded by investors, as we have an unparalleled track record for rating accuracy in Africa. GCR's bank rating methodology covers commercial banks, merchant banks, building societies, discount houses, finance houses and other similar banking institutions.

Incorporating both quantitative and qualitative factors, GCR's ratings reflect an evaluation of the organisation's current financial position, as well as how the financial position may change in the future. In its quantitative analysis, GCR focuses on fundamentals, analysing an institution's historical and current financial performance and using this as a foundation for developing expectations regarding its future financial performance and risk profile, under both normal and stressful operating scenarios. In establishing other strengths and weaknesses that could potentially influence an institution's future financial performance, emphasis is also placed on assessing the operating environment (including both economic and industry risk), strategy, market position, diversification, depth of management, as well as risk management policies and procedures. While GCR's bank rating methodology focuses largely on rating a banking institution's ability to honor all its general obligations (i.e. deposits and other liabilities) in a timely manner, it is also relevant to specific debt issues.

1. Analysis of the operating environment

GCR conducts an in depth analysis of the economic fundamentals and regulatory environment which impact on the banking sector in a particular country on an ongoing basis. The basic structure of the banking system which includes analysis of competition and concentration in the market is also carried out and, where applicable, a peer group is established and analysed for comparative purposes.

2. Preliminary analysis

Prior to meeting with management, preliminary analysis is conducted based on publicly available information (i.e. published financial statements, publications of the banking supervision authorities and other relevant sources). Further to this, management of the banking institution is asked to provide answers to GCR's standard Bank Rating Questionnaire, which addresses some of the more in depth and often not publicly available information, focusing on diversification of assets, liabilities and revenue streams, asset quality, as well as risk management policies and procedures. In addition to this, GCR's Bank Rating Questionnaire outlines the subjects to be reviewed during the due diligence visit.

Preferably, the written answers and relevant documents requested in the questionnaire should be received prior to GCR's meetings with management. This enables the analysts involved to gain a thorough understanding of the bank's fundamentals and identify the specific issues to be discussed in the due diligence meetings. It is important to stress that due to the sensitive nature of some of the information requested in the questionnaire, total confidentiality is guaranteed to all clients.

3. Due diligence

A team of analysts will spend a day with management at the location of the rated institution discussing the following:

4. Rating report

Following the due diligence exercise, a thorough analysis of risk, asset composition & quality, funding & liquidity, capital structure, financial performance and future prospects is compiled in a draft rating report. This is sent to management of the banking institution for comments on style and factual accuracy.

5. Rating panel meeting

Once management have commented on the report, it is distributed to the members of GCR's Rating Panel for their individual assesment of the bank's credit risk. At the rating panel meeting, both the primary and the secondary analyst involved in the process present the report to the panel, after which the Rating Panel accords a provisional rating. Before being disseminated in any way, the rating and the rating rationale are communicated directly to management.

6. Publication and management's options

Once the rating has been accorded, management has the following options at its disposal:

Release of a Public Rating

The rating is disseminated to GCR's subscription clients and, where agreed by management, to the general public through press releases. It is at this stage that management can amend the report to exclude any information considered to be of a sensitive nature.

Maintain a Private Rating

The company also has the right to keep the rating private. In such cases, the rating relationship is kept completely confidential. In general, this option may be useful to banks placing debt issuance with private investors, or banks seeking guidance in achieving a higher rating in future. 

Appeal the Rating

If management feels that some aspect of the bank's operation should be given greater or lesser weight in GCR's rating evaluation, it may appeal the rating for further consideration based on additional information provided.

The following guidelines provide a general overview of the quantitative and qualitative factors that GCR considers when analysing a bank. For the sake of simplicity, this methodology refers to banks, although this term may be used interchangeably with building societies, discount houses, finance houses and other banking institutions.

GCR's opinions are based on a clear understanding of the fundamentals of the rated organisation and the industry in which it operates. These guidelines are intentionally broad in scope, recognising that assigning credit ratings is a dynamic process and that each entity possesses unique characteristics and assumes varying levels of risk.

GCR's analytical process focuses on the following key areas:

1. Economic risk

Clearly understanding the fundamentals of the environment in which the bank operates is of foremost importance. This is especially the case in emerging markets, where the political and economic environment tends to be significantly more volatile. GCR focuses on the strength and weaknesses of the country's economic and political situation, always bearing in mind the effects this could have on the banking industry, and accordingly, a rated institution.

One of the most important aspects in examining the direct effects of the economy on the performance of the banking sector is the size of the economy, its composition and growth prospects. This is especially important when considering the rate of monetary and credit growth in relation to economic growth, as well as the trends in savings and investment in the economy. GCR also places emphasis on understanding the potential structural problems facing the economy, correction of which may require policies that depress economic growth (e.g. structurally high inflation). These factors determine interest rates and demand for credit, and they significantly influence the bank's operating environment and accordingly its strategy, growth, liquidity and profitability.

Apart from this, GCR analyses the fundamentals of various other industrial sectors within the economy, concentrating on the structure and financial strength of the public and private sector. In this process the sectors that are most likely to be affected by an adverse movement in the economy are identified, as high exposure to such sectors could result in the deterioration of the bank's asset quality.

2. Industry risk

In understanding the risks inherent in the banking industry, GCR places great emphasis on analysing the basic structure of the banking system (including its relative size, regulatory environment, number of participants and transparency).

Firstly, the percentage of funds in the economy that flow through the banking system, as well as the relative depth of capital markets is considered. Cognisance is then taken of the dynamics of competition within the industry including both bank and non-bank institutions. GCR examines the barriers to entry, consolidation trends, number of banks and bank branches relative to population, foreign participation, level of price sensitivity and market sophistication.

Great emphasis is placed on the regulatory environment in which the bank operates. In this respect, the quality of the banking supervision framework is closely examined. Apart from an in depth understanding of the legislation governing the industry, GCR insists on scrutiny of instruments used to monitor the banking system, which include the forms and quality of reporting of banks to the regulatory authorities, as well as frequency and quality of on-site examination and off-site surveillance conducted by the banking supervision authorities. The actions and measures that regulatory authorities are empowered to use in avoiding problems and potential failures of banks within the system are identified. To this end, GCR considers the level of solvency and liquidity support to banks from the relevant authorities.

Once the operating environment of a rated institution is analysed, GCR determines the market position of the bank based on its market share and core competence. Advantages and vulnerabilities arising from its market position are examined, concentrating on diversification, strategy, management and systems.

As the success of a bank is reliant on its strategy and, to an extent, its ability to differentiate itself from other players in the industry, the bank's chosen target market and its strategic position to service this segment is scrutinised. To this end, diversity of products offered, as well as diversity of the bank's customer base is examined. This is important in establishing diversity of the bank's revenue streams and potential vulnerability with regards to dependency on a single product, market segment, geographical area and/or type of product.

GCR examines the corporate structure and various divisions and subdivisions within the organisation, determining the level of complexity and depth of the organisation's management and operational systems.

One of the most important aspects of the rating process is the level of confidence GCR develops in management and its strategies. GCR's assesment of management includes the evaluation of both the short and long term planning process, the level of attention given to risk management policies and procedures (especially in credit, market and liquidity risk areas) and the established management succession plans. In this process GCR focuses on quality and depth of management, their established track record, ability to manage through stressful periods, as well as the ability to manage new business lines. One of the focal areas in analysis of the bank's performance is an evaluation of the quality of the strategic and financial planning. For this purpose GCR uses a comparison of the bank's financial results with management's plans and budgets. With regards to management succession planning, ‘key man' reliance and strength of middle management are assessed.

Another of the focus areas which GCR evaluates is the level of sophistication and quality of the bank's information technology systems. Here, emphasis is placed on storing and retrieval of data, both in individual branches and in the entire network. As it affects both the quality of operation and services delivered, GCR examines the type of network, as well as the communication systems in place. A bank's relative position to its peers in available technological advances can affect the bank's market position. In addition, risk management procedures enhanced by high quality information systems provide for better monitoring and lower risk.

Having examined qualitative factors affecting a bank's financial performance and risks, GCR focuses on linking quantitative data with qualitative information in order to closer assess the risk of timely payment of interest and/or principal. In this process GCR firstly examines the quality and mix of assets as the primary sources of variability in a bank's creditworthiness.

GCR examines the composition of the bank's assets, including relative proportions in different credit-risk assets (e.g. liquid assets, investment securities, loans and advances). It is important to note that in examining the bank's asset composition, certain off balance sheet exposures (e.g. contingent liabilities) are brought on balance sheet, whilst certain intangible items (e.g. goodwill) are subtracted from assets and, correspondingly, capital. Whilst cognisance is taken of the annual growth and year-on-year change in asset composition, particular scrutiny is placed on the bank's loan book.

GCR focuses on identifying concentrations in the loan book by type of loan, client, collateral, industry sector, geography and maturity. High exposures to individual clients (measured as a percentage of the bank's capital base) are also reviewed.

Any improvement or deterioration in asset quality can significantly influence the bank's profitability and its capitalisation. In assessing asset quality, GCR focuses on the breakdown of all credit exposures in arrears, as well as large individual non-performing loans (“NPLs”). Here changes in levels relative to past performance, as well as industry trends, are monitored.

One of the most important aspects of the bank's asset quality is the level of provisions raised against the NPLs, including both general and specific provisions, as well as interest suspended. Although cognisance is taken of the level and nature of the collateral held against non-performing exposures, this is excluded from GCR's asset quality ratios. There are two main ratios measuring the level of asset quality, namely;

In addition to this, GCR also focuses on charge-offs, liquidation of provisions and recoveries that took place during the period under review.

One of the main factors determining the bank's ability to continue meeting its obligations in a timely manner is the stability of its funding. Whilst the strength of the bank's funding base determines its ability to weather bad times, it also provides financial flexibility for growth during periods of stable financial performance.

GCR examines the bank's funding strategy establishing the main sources of funding (e.g. retail and wholesale markets) and the bank's presence and competitiveness in sourcing funding from these markets. Assessing the bank's funding capability requires an understanding of the local deposit market and the history of the franchise. The nature of the bank's deposit base determines the relative stability and influences its cost of funding.

In determining the strength of the bank's funding base, GCR focuses on the diversity of funding sources, examining concentrations of the deposit book by client, industry sector, geography and size. In addition, it is important to understand the flow of funds within the institution and, to this end, deposit flows and maturity are examined. The bank's liquidity is tested under various scenarios and potential maturity mismatches between the bank's assets and liabilities are identified.

Cognisance is taken of management's philosophy and planning with regards to liquidity. GCR takes cognisance of an institution's ability to access debt in the capital markets, as well as the possession of assets that can be liquidated without significant impairment to value. In this respect liquidity of assets is closely examined, including short term deposits, the marketable securities, ability to sell or securitise loans, any liquidity facilities with the central bank or other sources of asset liquidity.

The liquidity ratios, which GCR focuses on are:

6. Capital adequacy

GCR focuses on tangible capital, as well as a bank's ability to grow its capital base through the retention of its earnings. In this process, the composition and quality of the bank's capital are examined, including levels of common equity, preferred stock, convertible and subordinated debt, minority interests, asset revaluation and unrealised capital gains, as well as loan loss reserves (over and above probable losses). In order to take a more conservative stance in assessing the level of the bank's capital adequacy, certain intangibles and goodwill are excluded from the capital base in GCR's analysis. In instances where a holding company structure is involved, potential support from the parent company, as well as the level of double leverage is considered. Whilst GCR focuses on the absolute quantum of the bank's capital base in order to asses its ability to weather extraordinary and unexpected losses that could arise, the bank's access to external sources of capital and long term funding is taken into consideration as well.

In general, a solid capital base provides a basis for growth, finding funding alternatives and creating loan loss provisions. The bank's capital ratios are to a great extent determined by the regulatory requirements and GCR compares the bank's capital adequacy position with domestic capital requirements. Qualifying primary and secondary capital is compared with the perceived level of risk in a rated institution's business. Here, the risk weighted capital adequacy ratio is considered to be amongst the most important parameters of the bank's capital adequacy.

In addition to the risk weighted capital adequacy ratio, GCR focuses on a number of other ratios measuring the level of capital adequacy of a rated institution, including:

Finally, in addition to the quantitative measures determining the level of capital adequacy, cognisance is taken of the management's philosophy regarding risk assets, loan leveraging of its capital base and capital projections.

7. Risk management

GCR insists on gaining an in depth understanding of the institution's risk management policies and procedures. The risk management structures (including the structure and authority of various risk committees and subcommittees) and policies with regards to credit and market risk, as well as asset and liability management, are particularly scrutinised.

The level of liquidity, interest and market risk is to a great extent determined by the bank's asset and liability management (“ALM”). In examining this, the structure and authority of the bank's Asset and Liability Management Committee (“ALCO”) is considered. GCR examines the policies of the ALCO, as well as the various limits set by it for the different type of risks and the impact of its decisions on the bank's daily risk management.

The balance between the bank's interest sensitive assets and liabilities is analysed using traditional gap measures. Finally, the institution's use of derivative instruments and other off-balance sheet instruments are reviewed, in order to understand the risks managed and the effectiveness of methodologies employed.

8. Financial performance and ratio analysis

One of the key factors in assessing the long term viability of any organisation is profitability. The first step is to examine the split between interest and non-interest income and the bank's relative dependency on certain types of income. Here, GCR analyses how successful the bank has been in optimising the risk/return tradeoffs in each of its key businesses. Every item on the income statement is examined in detail, determining year-on-year movements in various types of income and expenses. In measuring the bank's relative profitability, some of the most important ratios considered are:

The quality of the bank's profitability and efficiency ratios to a large extent determines the bank's long term prospects. In addition to this, based on the comparison between the historical financial performance and the original budgets, GCR constructs a model assessing the accuracy of the new budgets and to assist in determining future prospects.

Conclusion

While thorough quantitative analysis is important, the qualitative characteristics of GCR's analysis cannot be overemphasised. It is critically important to look “beyond the numbers” and to evaluate the intangible strengths and weaknesses of an entity. At the core of GCR's analysis is the understanding of the strategic characteristics of an organisation and the quality of management. Our emphasis is on determining how these strategic aspects will affect the organisation's flexibility and capacity to weather adverse market circumstances.