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The Credit Rating Process of Credit Rating Agency of Bangladesh Ltd (CRAB) Part 1.4 ABSTRACT

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redit Rating Agency of Bangladesh Ltd. (CRAB) was established in 2003 at the initiative of some leading personalities in private sector and institution of the country with the commitment to contribute to the development pg the capital Market by providing quality ratings and comprehensive research services. CRAB was incorporated as a private limited company in 2003 and receives its certificate of commencement of business in the same year. In 2004 CRAB was granted license by the Securities and Exchange Commission (SEC) of Bangladesh (under the credit rating company’s rules 1996) for operating as a credit rating Company. Within short span of time, CRAB has established its reputation as a reliable source of independent opinion on risks based on systematic and standardized analysis done by professionals. Part 1.4 Methodologies For the preparation of the report I have used basically the secondary data that are obtained mainly from CRAB’s distinctive website, BASEL II (a new capital adequacy) formulated by Bangladesh Bank, requirement for credit ratings approved by Securities & Exchange Commission (SEC), Major portion of data is collected from the official publication of Annual Reports of different years by the company. Analyses tools and techniques required few assumptions to be made which were considered based on utmost sincerity by the analysts and experts’ suggestions & business development teams’ view as well. Again I have used CRAB’s corporate brochure, various rating report of the companies including (Bank, manufacturing co, trading co, insurance, telecom & so on), CRAB’s client lists, ICRA & ACRAA website, company’s annual report, and finally my individual judgments have been used to develop the overall framework of this report. Part 1.5 Limitations of the study For exclusive report it requires highest effort which asks for a huge time, money and manpower. Moreover, no corporate house likes to disclose their strategic plans or other key points to outsiders for their business interest. Another challenge was to conduct the financial analysis as we concentrate to Marketing, there is lot more knowledge and expertise required to do it. In spite of these the guys were so busy that they were not capable to give me enough time to expand their helping hand to develop an exclusive report. Moreover some latest data could not be collected due to confidentiality, which was essential for my study. The other limitations of the study are as follows: • Limitation due to dependence on secondary data. • Lack sufficient previous years’ information in an organized way. • CRA’s policies do not permit of disclosing some sensitive information and data for obvious reason that poses as an obstacle to evaluate my report.


• There are four Credit Rating Agency in Bangladesh, for this it was difficult for me to collect the data and evaluate them. Part 1.7 Executive Summary Credit rating agencies (subsequently denoted CRAs) specialize in analyzing and evaluating the creditworthiness of corporate and sovereign issuers of debt securities. In the new financial architecture, CRAs are expected to become more important in the management of both corporate and sovereign credit risk. The logic underlying the existence of CRAs is to solve the problem of the informative asymmetry between lenders and borrowers regarding the creditworthiness of the latter. Issuers with lower credit ratings pay higher interest rates embodying larger risk premiums than higher rated issuers. Moreover, ratings determine the eligibility of debt and other financial instruments for the portfolios of certain institutional investors due to national regulations that restrict investment in speculative-grade bonds. The banking sector in Bangladesh passed through significant changes in terms of structure and policies. Starting with six nationalized commercial and a few specialized banks after independence, the total number of banks has reached 48 at present including private and foreign commercial banks. The Bangladesh financial sector is under going through a phase of transaction, transformation and convergence. The regulators are more active then ever before to bring the sector up to an international standard. The competitive environment created with the presence of too many banks in a small economy has also been forcing the banks to increase risk in both sides of the balance sheet. In the asset side, banks are shifting from traditional financing from sector corporations to private sector group business, housing, automobile commercial vehicles 5SMEs. On the liabilities side the transformation is from passive retail strategy to a very active retail trust to attract and retain customers and increase in deposit base. Keeping pace with the global changes, the banking sector of the country has been undergoing a remarkable change during the last couple of years. In order to bring the sector in line with the international norms, the central bank has taken a number of steps under the Financial Sector Reform Program. During the last couple of years, Bangladesh Bank has taken a number of steps through prudential circulars and best practices guidelines to improve the governance practice of the sector. Some of the worth mentioning steps were: limiting the percentage of family shareholding and directorship from the same family, limiting the number of directors in the board, obtaining prior permission of the central bank in appointment and termination of the services of CEO, issuance of best practice guidelines for core risk management, mandatory requirement of Risk grading system in order to minimize risk of credit etc. Most recently, the central bank introduced the mandatory annual credit rating requirement for all schedule banks. The Bank for International Settlement (BIS) has finalized the Basel-II Accord after issuing several consultative papers and impact studies and published the same under the title “International Convergence of Capital Measurements and Capital Standards” in June 2004 to be effective from 2006. Most of the developed and developing countries have drawn up the implementation plan of Basel-II in their respective countries. The neighboring countries are now implementing Basel –II Accord. The Bangladesh Bank has also decided to go for adoption of Basel-II with effect from January 2009 with parallel run BASEL I and II with effect from January, 2009. Banks and Financial Institution (FI) rating are the OPINION of CRA on the ABILITY and WILLINGNESS of a Bank/FI to discharge its obligations including depositors’ money in timely manner that is as per contract. These opinions are arrived at after a through analysis of both quantitative and qualitative areas of the Bank. In Bangladesh CRA offers two types of ratings- Long Term and Short Term. Long-term ratings are valid for maximum one year while short-term rating carries a validity of maximum six months. Part 2.1 Introduction


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he term “Credit Rating” can be analyzed by dividing it in two parts – credit and rating. Credit is taking money or some benefits from a lender for generating some benefits with a promise to pay back the principle and the interest after a specific time period. Rating usually denotes to a symbol or on a relative judgment of something on a scale. So the entire term ‘credit rating’ can defined as a judgment or an opinion on the quality of a credit, whether the creditor or the borrower is financially capable to meet the obligations i.e., principle and interest. A credit rating assesses the credit worthiness of an individual, corporation, or even a country. It is an evaluation made by credit bureaus of a borrower’s overall credit history. Credit ratings are calculated from financial history and current assets and liabilities. Typically, a credit rating tells a lender or investor the probability of the subject being able to pay back a loan. However, in recent years, credit ratings have also been used to adjust insurance premiums, determine employment eligibility, and establish the amount of a utility or leasing deposit. Credit ratings are used by investors, issuers, investment banks, broker-dealers, and governments. For investors, credit rating agencies increase the range of investment alternatives and provide independent, easy-to-use measurements of relative credit risk; this generally increases the efficiency of the market, lowering costs for both borrowers and lenders. This in turn increases the total supply of risk capital in the economy, leading to stronger growth. It also opens the capital markets to categories of borrower who might otherwise be shut out altogether: small governments, startup companies, hospitals, and universities. Part 2.3 Literature Review In terms of the BRPD Circular Letter No. 05 dated May 29, 2004 it was made mandatory for the banks to have themselves credit rated to raise capital from capital market through IPO. The issue has been reviewed further and with a view to safeguard the interest of the prospective investors, depositors and creditors and also the bank management as a whole for their overall performances in each relevant areas including core risks of the bank, it has now been decided to make it mandatory from January 2007 for all banks to have themselves credit rated by a Credit Rating agency. Banks are, therefore, advised to take necessary measures from now on so that they can have their credit ratings in all relevant areas as well as the bank management. Banks will be required to complete their credit rating by June 30, 2007. The credit rating will be an ongoing process i.e. credit rating should be updated on a continuous basis from year to year, within six months from the date of close of each financial year. The rating report completed in all respects be submitted to Bangladesh Bank and made public within a period of one month of the notification of rating by the credit rating agency. Banks will disclose their credit rating prominently in their published annual & half yearly financial statements. Part 2.4 Objectives of the Report PRIMARY OBJECTIVE To correlate theoretical learning acquired through classroom study with the real life business situation faced as an internee during the Internship period. SECONDARY OBJECTIVES The secondary objectives regarding this study are as follows: 1. Depicting the credit rating process of CRAB.


2. To analyze and identify the quantitative factors of rating methodology of bank. 3. To analyze and identify the qualitative factors which are considered at the time of credit rating of the bank. 4. Find out those key ratios significantly contributing differences in credit rating. 5. Predicting the potential impacts of CRAs on our financial market. 6. Finally making some recommendations to improve the activities of the bank and credit rating practices of the country to better coup with the international practices. Part 2.5 Scope of the Study Since I have selected my topic “Credit Rating Process of Credit Rating Agency of Bangladesh Ltd. (CRAB)”, I have opportunity to collect different documents relating to the credit rating and banking sector. Most of the financial analyst of CRAB helped me to prepare a constructive report by providing relevant paper and files for which I was highly encouraged. Besides this I have faced very difficulty to prepare a report on this topic. To prepare this area requires time, much contract, careful attention and study. Part 2.6 Sources of the Study I have prepared the report by conducting three months internship program by analyzing qualitative and quantitative information collected through primary and secondary sources. To analyze the regulatory environment of the rating agencies in both national and international level, internet provides the most of the information. Sites of SEC of India, Malaysia, US and Bangladesh were visited and necessary documents were retrieved. Sites of many major rating agencies around the world were visited to get a clear understanding on rating industry.  Primary Source: The primary data was collected by convincing the financial analysts of the Credit Rating Agencies.  Secondary Sources: • Credit Rating reports of CRAB and CRISL of the banks and others corporations. • Annual Report of Selected Banks-Top 10Banks Based from 2003-07. • Circulation and announcement of Bangladesh Bank. • Circulations of Stock Exchange Commission and BRPD. • Other related published documents, books and journals etc. Part 2.7 Definition of Credit Rating A credit rating is an opinion of the credit agency on the future ability and willingness of the borrowing entity/ Issuer of debt instruments/ obligations to make payment of principal and interest as per the terms of the underlying contract. It measures the relative probability of borrowing defaulting on its obligations over its life and also an assessment of the severity of monetary loss of the lender should such default occur.


The primary objective of Credit Rating is to provide guidance to the investors in determining credit risk associated with a debt instrument/ credit obligation. The Credit Rating is neither a generalpurpose evaluation of the issuer/ entity nor an opinion on all the debt contracted/ to be contracted by such an entity. Credit Rating is not a recommendation to buy or sell or hold securities / debt obligations. It is only an opinion of the Credit Rating Agency on the relative capacity of the issuer to service its debt obligation as per terms of the contract with particular reference to the instrument being rated. Part 2.8 Definition of Credit Rating Agencies A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings. In most cases, the issuers of securities are companies, special purpose entities, state and local governments, non-profit organizations, or national governments issuing debt-like securities (i.e., bonds) that can be traded on a secondary market. A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued. The Rating Agency does not guarantee the completeness or accuracy of the information on which the rating is based. A credit rating agency has to rely extensively on the information, clarifications and opinion provided by the Issuers as well as those obtained from other professional agencies like auditors, bankers, solicitors, investors, customers and suppliers, etc. The Rating, usually expressed by way if an alphabetical or alphanumeric symbol, is an easily understood tool enabling the investors to differentiate between credit instruments on the bases of underlying credit quality. A Rating dose not gives any direct or indirect assurance or guarantee against the probability of default. The Rating Agency , in fact, endeavours to arrive at a relative rankings in terms of the probability of default in a debt offering based on its predictive tools and techniques, rigorous process of Due Diligence, internal and external research that constitute its analytical framework. It enables lenders/ investors to take an informed decision based on their individual risk return preferences. It also enables the lender to assess the risk underlying a debt offering and factor the same in his lending/ pricing decision. A Rating tries to establish a linkage between risk and return. The Rating being an opinion, subjective and judgemental in nature, there can not be a precise correct or incorrect Rating, the endeavour always at a “fair” Rating. When there is a chance of default in repayment, the borrower is assigned a low grade and when the borrower has the sound financial health to meet its obligations it is awarded a high grade. The grades or rates assigned to the borrower are called rating symbols or rating notch. Rating notches range from “AAA” to “D”. “AAA” is the highest safety grade in the rating scale for an entity that indicates a safe and timely repayment of borrowed money whereas “D” signals a current or future default in repayment of the borrower. The table in the next page summarizes the rating scales used by premier rating agencies: Generally, international rating agencies assign short-term and long-term credit ratings. 

Short-term rating gives the benchmark of the likelihood of borrower’s default within one year.

Long-term rating evaluates the likelihood of default over longer time (up to the lifetime of the securities issued).


Rating Grade

Rating Symbol / Rating Notch

Definitions

AAA

Highest Safety

AA+, AA, AA-

High Safety

A+, A, A-

Adequate Safety

BBB+, BBB, BBB-

Moderate Safety

BB+, BB, BB-

Inadequate Safety

B+, B, B-

Risky

C

Vulnerable

D

Default

Investment Grade

Speculative Grade

Default Grade

It is important to note that ratings are not equal to or the same as buy sell or hold recommendations, it is an opinion on the creditworthiness of a person or an entity or even of a country. Ratings are rather a measure of the borrower’s ability and willingness to repay borrowed money. The rating agencies fall into two categories: (i) recognized; and (ii) non-recognized. The former are recognized by supervisors in each country for regulatory purposes. In the United States, only five CRAs of which the best known are Moody’s and Standard and Poor’s (S&P) are recognized by the Security and Exchange Commission (SEC). The majority of CRAs such as the Economist Intelligence Unit (EIU). Institutional Investor (II) and Euro money are “non recognized”. There is a wide disparity among CRAs. They may differ in size and scope (geographical and sectoral) of coverage. There are also wide differences in their methodologies and definitions of the default risk, which renders comparison between them difficult. Part 2.9 Origin of Credit Rating The credit rating system emerged as a private sector institution in the middle of the 19 th century. The precursors of bond rating agencies were the mercantile credit agencies, which rated merchants' ability to pay their financial obligations. In 1841, in the wake of the financial crisis of 1837, Louis Tappan established the first mercantile credit agency in New York. Robert Dun subsequently acquired the


agency and published its first ratings guide in 1859. A similar mercantile rating agency was formed in 1849 by John Bradstreet, who published a ratings book in 1857. In 1941 Poor Publishing merged with Standard Statistics to form the S&P. In 1960 S&P acquired a stake in Fitch Investors Service rating agency operations. The ratings symbols that are today used worldwide that were developed by Fitch were incorporated into the S&P ratings. In 1966 McGraw Hill an American publishing house bought out S&P and still today they own the company. The ratings developed by Moody in early 1900s, were later applied to industrial companies and in the 1970s they began rating commercial paper and euro bonds. Since 1962 Moody’s has been a subsidiary of the Dun and Bradstreet Corporation (D&B). The most significant new entry in the United States since that time has been the Chicago-based Duff and Phelps, which began to provide bond ratings for a wide range of companies in 1982. Another major ratings provider--McCarthy, Crisanti, and Maffei-was founded in 1975 and acquired by Xerox Financial Services before its fixed income rating and research service was merged into Duff and Phelps in 1991. In the beginning the CRAs sold their information to investors, rather than charging issuers as is the case today. Some issuers were skeptical in the beginning and regarded the CRAs as intruding, but in the end they were forced to provide the agencies with information because absence of information would affect their rating. In these initial stages the ratings provided by CRAs were financed through the sale of publications. Following the invention of the photocopier however and ease at which these publications were copied, CRAs started to charge the issuers. Since the beginning of the 1980s, the role and importance of rating agencies has increased. As it stands today they hold a central role in the international system of capital allocation. Part 2.10 Role of Credit Rating Agencies Rating merely provides a relative ranking of issuers with regard to the risk of default. CRAs publish historical data on the default rates associated with rating. These data provide important information and give an idea of how the agencies’ rating have performed in past. The rating agencies are an integral component of the financial market. Done properly, their evaluations of credit risk are essential to many market participants who lack the resources or skill to make an independent evaluation. In recent years credit rating agencies (CRA) have become increasingly important in the management of financial market risk. CRA are commercial firms that receive payment for publishing an evaluation of the creditworthiness of their clients. This information is especially useful when borrowing takes place through the issue of securities, rather than by bank loans, since buyers of securities do not know the issuers as well as banks usually know their customers. CRA originated in the USA at the turn of the century and concentrated on rating corporate bonds. Their activities subsequently increased in scope and scale. At present no major type of security, issuer or geographic area is excluded. CRA now define a truly global benchmark for credit risk. Published ratings are not only closely observed in the market place. They are significant for regulation as well. Since CRA judgments define a globally uniform benchmark, they are attractive as a reference for international regulatory standards as well. A good case in point is the recent proposition by the Bank for International Settlements to use ratings to calculate capital adequacy ratios for banks. The major roles played by Credit Rating Agencies are given below: • • • •

Investor protection via independent, 3rdparty opinion on the credit risk or default risk of issuers/issues Distill complex financial structures into user-friendly symbols Provide a common yardstick to evaluate default risk for investment decision making Monitor and disseminate credit opinions on rated issuers/issues in a timely and efficient manner


• • • •

Bridge the information gap between issuers and investors and a source of credit surveillance for investors Assist regulatory authorities in developing and facilitate implementation of prudential guidelines requirements e.g. BASLE II Provide a performance benchmark -3rdparty evaluation of company’s business and financial performance within and across industries Tracks and monitor performance of economy/industries, as well as default statistics

Part 2.11 Background of Credit Rating Agencies in Bangladesh Although the concept of credit rating emerged in early twentieth century in the financial market of USA, it is still new in the developing countries like Bangladesh. Long after a century of its emergence, Securities and Exchange Commission (SEC) of Bangladesh promulgated rules regarding the operation of rating agencies in 1996. No rating agency was licensed in the country till 2002, hence no rating was published. It was the South-east Bank Limited to be rated for the first time in Bangladesh by premier credit rating agency CRISL, in November 2002. After that delayed initiation, hundreds of institutions and few bonds are rated each year. CRISL and CRAB are the two licensed credit rating agency of the country permitted to rate the entity and debt instruments under the Credit Rating Companies Rules 1996. CRISL and CRAB earned their certificate of registration in August 2002 and February 2004 respectively. Here is an overview of both the CRAs: Part 2.12 About CRAB Credit Rating Agency of Bangladesh Ltd. (CRAB) was established in 2003 at the initiative of some leading personalities in private sector and institution of the country with the commitment to contribute to the development pg the capital Market by providing quality ratings and comprehensive research services. CRAB was incorporated as a private limited company in 2003 and receives its certificate of commencement of business in the same year. In 2004 CRAB was granted license by the Securities and Exchange Commission (SEC) of Bangladesh (under the credit rating company’s rules 1996) for operating as a credit rating Company. Within short span of time, CRAB has established its reputation as a reliable source of independent opinion on risks based on systematic and standardized analysis done by professionals. Part 2.13 Mission & Objectives Mission: Effect significant contribution towards qualitative development of the money and capital markets and enhancement of transparency of financial information and credibility of the corporate sector in Bangladesh. Objectives: The objectives of Credit Rating Agencies are: To perform the credit rating of various debt instruments as Commercial papers, Bonds and Debentures, Islamic bonds, Preference shares, Equity instruments, Rights issue, Mutual fund units etc. To perform grading of various institutions as banks, non banking financial institutions, insurance companies, corporations, non-corporations, societies, trusts or individuals or their clients for purposes requested clients or required by authorities. To accumulate, process and offer information services in broad areas for the use of organization and clients at different levels.


To provide consultancy and advisory services in broad areas to clients at different levels. To act as trustees of any debentures, bonds, securities, commercial papers or any other obligations and to exercise the powers of executor, administrator, receiver, treasurer, custodian in respect of such debts and securities Part 2.14 CRAB Corporate Profile: Board of Directors: Chairman Mr. M Syeduzzaman Former Finance Minister, Govt. of Bangladesh

Vice Chairman Mr. Md. Matiul Islam, FCA Chairman, Industrial and Infrastructure Development Finance Company Ltd. Former Secretary of Finance, Govt. of Bangladesh

Directors Mr. Samson H. Chowdhury Chairman, Astras Ltd.Chairman, Square Group

Mr. Syed Manzur Elahi Chairman, Apex Footwear Ltd. & Apex Tannery Ltd.& Former Advisor to the Caretaker Govt. of Bangladesh.

Mr. M. Anis Ud Dowla Chairman, ACI Ltd.

Md. Fayekuzzaman Managing Director, Investment Corporation of Bangladesh

Mr. M. Haider Chowdhury Chairman National Life Insurance company Ltd.


Mr. A K M Rafiqul Islam, FCA Managing Director, Pragati Insurance Ltd. Mr. Mir Mustafizur Rahman Former Secretary of Finance, Govt. of Bangladesh Mr. A. S. M. Quasem Chairman, New Age Group

Mr. Sohail Humayun Managing Director, Unicorn Equities Ltd

Mr. M Faizur Rahman Chairman, Asian Surveyors Ltd.

Selim RF Hussain CEO & Managing Director,IDLC Finanace Ltd.

Managing Director: Hamidul Huq Hamidul Huq, Managing Director of Credit Rating Agency of Bangladesh Limited is an MBA From IBA, Dhaka University. He Joined CRAB in June, 2008. Prior to joining the CRAB, Mr. Huq was the Managing Director of United Commercial Bank Ltd. Mr. Huq brings with him vast experience in commercial as well as development banking having held senior positions in various institutions in these areas.


Part 2.15 Rating Committee Members are: The credit rating process has at its apex a high powered Rating Committee composed of personalities with impeccable integrity, judgment and standing. The Committee is entrusted with the responsibility for finalization of the Rating Report and Fixation of the “Rating Award� to client entities and/or instruments. Currently the members of the Committee are: Dr. AB Mirza Md Azizul Islam Former Advisor,Government Of Bangladesh.

Dr. A K M Gulam Rabbani Former Secretary & Member Planning Commission. Former Director General of Bureau of Statistics

Prof. Muzaffar Ahmed Noted Economist Former Director, Institute of Business Administration, Dhaka University

Dr. Mohammad Haroonur Rashid Former Secretary and Member Planning Commission and Chairman of Securities & Exchange Commission of Bangladesh

Faruq Ahmad Siddiqi Former Chairman, Securities & Exchange Commission

Dr. Salehuddin Ahmed Former Governor of Bangladesh Bank

Mr. Asif Ali Former Comptroller & Auditor General of Bangladesh

Dr. Mohammad Sohrab Uddin Former Deputy Governor, Bangladesh Bank


M. Shamsul Alam Chairman of Sadharan Bima Corporation Mr. M. Azizul Huq Noted Expert on Islamic Banking & Former Managing Director of Social Investment Bank Ltd. Former Executive President, Islami Bank Bangladesh Ltd

Hamidul Huq Managing Director, Credit Rating Agency of Bangladesh * The Committee composition may change from time to time.

PART 2.16 A SNAP SHOT OF THE COMPANY


Part 2.17 Rating Service Provided by CRAB CRAB is a full service credit rating agency offering ratings of all kinds of financial instruments and entities including those required by regulatory authorities. Our services cover ratings of securities issued by manufacturing companies, corporate bodies, commercial banks, non-bank financial institutions, investment banks and mutual funds, among others. The obligations include long term instruments such as bonds and debentures, medium term instruments such as fixed deposit programmes, and short term instruments such as commercial papers. CRAB also offers ratings of structured obligations and sector specific debt obligations such as instruments issued by Power, telecom and Infrastructure companies. The other services offered include Credit Assessment of large, medium and small scale units for obtaining specific lines of credit from commercial banks, financial institutions and financial services companies. CRAB offers the following Rating Services: •

Entity Ratings:

Entity ratings are a measure of a company’s intrinsic ability and overall capacity for timely repayment of its financial obligations. They are mandatory ratings required for any regulatory compliance or voluntary ratings that may be sought by companies to enhance corporate governance and transparency. These ratings are useful for benchmarking a company against its peers, enhancing investors’ confidence, market profiling, reducing time for future debt ratings, enhancing a company’s standing for counterparty risk purposes and facilitating credit evaluation for bank borrowings and bank lines •

Financial Institution Ratings:

These ratings will assess the creditworthiness of financial institutions, i.e. commercial and merchant banks, non-banking finance companies, housing finance companies etc. While each of these entities has the same function, i.e. leverage on own funds and lend to others on a cost plus basis, there are significant differences in terms of scale of operations, and their internal control systems. Ratings of financial institutions focus on the risks that can possibly affect the operations of a finance company operating risks, financial risks and management risks. •

Corporate Debt Ratings:

Such ratings specifically assess the likelihood of timely repayment of principal and payment of interest over the term to maturity of such debts as per terms of the contract with specific reference to the instrument being rated. A missed or delayed payment by an issuer in breach of the agreed terms of the issue is considered as default. •

Equity Ratings (Initial public Offerings and Right Offerings):

Equity rating makes assessment of the relative inherent quality of equity reflected by the earnings prospects, risk and financial strength associated with the specific company. The rating is not intended to predict the future market price of the stock of a company, but to evaluate the fundamentals of a company, which ultimately act as important inputs in the price behavior of the stock of such a company over the medium term and long term. In the short term, the rating helps in reconciling the market sentiment with respect to the stock of a company to the long term fundamentals as reflected by the equity grade. •

Structured Finance Ratings:


Structured Finance Ratings are opinion on the likelihood of the rated structured instrument servicing its debt obligations in accordance with the terms. An SFR is generally different from the corporate Credit Rating of the originator and is based on the risk assessment of the individual components of the structured instrument. These components include legal risk, credit quality of the underlying asset, and the various features of the structure. •

Insurance Companies Rating/Claims Paying Ability Rating:

Such ratings assess the ability of the insurers concerned to honor policy-holder claims and obligations on time. Rating provides an opinion on the financial strength of the insurer, from a policyholder's perspective, which may act as an important input influencing the consumer's choice of insurance companies and products. The rating process involves analysis of business fundamentals, competitive position, franchise value, management, organizational structure/ownership, and underwriting and investment strategies. The analysis also includes an assessment of company's profitability, liquidity, operational and financial leverage, capital adequacy, and asset/liability management method. •

Mutual Funds Schemes Rating:

Mutual Funds Schemes rating is designed to provide Investors, Intermediaries and Fund Sponsors/Asset Management Companies with an independent opinion on the performance and risks associated with various Mutual Fund Schemes. Funds ratings incorporate various qualitative and quantitative factors affecting a fund's portfolio. Such analyses focus on the resilience to economic changes, assessing asset quality, portfolio diversification and performance, and liquidity management. •

Clientele Rating for Banks/Financial Institutions:

Clientele Rating service has been designed to assist the management of the loan portfolios of banks/financial institutions by bringing in the present and prospective clients under continuous evaluation and monitoring of CRAB’s rating unit. Clientele rating provides banks/financial institutions on a continuous basis with opinions on the relative credit risks (or default risks) associated with the existing and/or proposed loans of the clients. Part 2.18 Other Rating Services CRAB performs other rating assignments as requested by clients or required by regulatory authorities. The other service provided by CRAB is-

1. Grading Service 2. Advisory & Consulting Service 3. Information Service 1) Grading Service CRAB is equipped to offer specialized evaluation methodologies addressing exclusive and area specific requirements under the umbrella of Grading services. The services are meant for evaluation of different activities and entities belonging to multi-faceted industries. CRAB’s grading service is designed to provide an objective, credible and independent opinion on the quality of entities being examined with specific reference to parameters and issues unique to the sector/sub-sector. Construction and real-estate development activities, hospitals and diagnostic services, are examples of such sector/sub-sectors. 2) Advisory & Consulting Service


The Advisory & Consultancy Services will offer wide ranging management advisory services which include strategic counseling, restructuring solutions, financial feasibility, financial structuring/modeling, client specific need-based studies in the banking and financial services, corporate and other core sectors. CRAB is prepared to extend sophisticated Credit Risk Management services for banks and other lenders. CRAB advisory services are also available for project preparation, evaluation and execution. CRAB is also ready to offer advisory/consulting services to clients who are seeking to be more competitive in their operating spheres. Such advisory services will be useful for a variety of clients corporate entities, regulatory authorities, banks/financial service organizations, industry associations, local governments, government organizations, and multi-lateral agencies, through selective tie-ups with reputed organizations having expertise in specific sectors. 3) Information Service CRAB provides information service in the form of database, financial analysis, market analysis, market survey etc. The service is customized to specific need of the clients. For further information please contact through email or telephone. Part 2.19 Necessity of Credit Rating The motives act behind the entities’ paying fees to secure a credit rating depends on the surrounding regulatory environment and form of financial market. There are several reasons of getting a rating. The reasons are different in different markets and economies. The motives of getting a rating in Bangladesh are not identical as USA or UK. As same, the motives of American entities are not same as those of European or Australian entities. However, there are some common reasons for which the entities all over the world are spending money to get rating from the rating agencies. The identical reasons are enumerated here with in the context of Bangladesh: Market access: Any company that wishes to enter capital markets and issue debt in capital market is obliged to obtain a credit rating. Rating conveys the entity’s ability and willingness to the market participants regarding repayment of its borrowed money or equity capital. In Bangladesh, as per Credit Rating Companies Rules 1996, all the companies are required to be rated before issuing its debt or floating its equity share at premium in the market. Build up market reputation: New companies that seek to build a reputation in the international financial markets demand credit ratings to increase the exposure of their brand name. This brand exposure is important when companies for example initiate foreign direct investments. An entity with a higher rating is considered as a reputable organization. Recently, Delta Brac Housing – DBH has been awarded as an “AAA” rated company of the country that excels the company’s reputation that was reflected through the share price the company at DSE and CSE. Lower cost of funding: A less known company can lower their cost of borrowing if they obtain a higher investment grade rating. Banks or financial institutions consider rating as an indication of an entity’s performance measurement yardstick. Entities with a higher rating are sanctioned loan at a lower interest rate whereas a lower graded entity is charged at a higher interest rate. So, it is going to be a common practice of the country to require an entity to be rated itself before applying for a loan to the banks or financial institutions. Distinguish oneself from the competition: In sectors that are characterized by a limited number of competing companies such as the banking or insurance industry, a credit rating is a tool to distinguish them from the competition. Our banking


sector is an example of this practice. In 2006, only Standard Chartered Bank was rated “AAA” by CRISL that makes the bank unique. But in 2007, both Standard Chartered Band and HSBC operation of Bangladesh has been awarded the highest rating “AAA” by CRISL and CRAB respectively that creates some competitive advantage for both the banks. Regulatory Requirement: All over the world entities are rated for the regulatory bindings by the securities commissions and other authorities. In Bangladesh, SEC, Bangladesh Bank and Department of Insurance are the three regulators who issued regulations, circulars and notifications for the entities for rating. Our banks and insurances are now rated once in a year for these requirements of the regulatory authorities. Benefits to the Issuers/Companies Credit Rating of an issue would ensure due compliance with the relevant legal regulatory provisions of the Securities & Exchange Commission and Bangladesh Bank. CRAB opinion would help the issuer company to broaden the market for their instruments. As ‘name recognition’ is replaced by objective opinions, the issuer company may access the securities market more comfortably. Credit rating may help in stabilizing issuers’ access to the market even when the market price of listed equities is relatively unfavorable in the prevailing market conditions. Credit ratings of Entities would confer upon the companies a greater confidence of the market and enhance a greater access to the financing sources. Values to the Investors & Creditors : Credit rating gives market participants timely access to unbiased, objective, independent, expert, professional opinion on the quality of securities in a user friendly manner that may be relied upon for investment decisions Rating opinion would facilitate the investors to decide their portfolios by choosing investment options in the market according to their profiles and preferences. Credit rating would effect significant contribution towards developing the stock market investor confidence and enhancing the quality and perfection of the securities market, through provision of credible information for guidance of institutional and individual investors. Values to the Economy & the Capital Market : Assists in qualitative development of the money and capital markets and enhancement of transparency of financial information and governance of the corporate sector in Bangladesh. Credit rating assists the regulators in promotion and enhancement of the precision of the financial markets. Part 2.20 Project Part: Part 2.21 Rating Process CRAB’s rating process initiated on receipt of a formal request (or mandate) from the prospective issuer. A rating term, which usually consists of two analysts with the expertise and skills required to evaluate the business of the issuer, is involved with the Rating assignment. An issuer is provided a list of information requirements and the broad framework for discussions. These requirements are derived from CRAB’s experience of the issuer’s business and broadly cover all aspects that may have a bearing on the rating. CRAB also draws on secondary sources of information, including its own research division. The Rating involves assessment of a number of qualitative factors with a view to estimating the future earnings of the issuer. This requires extensive interactions with the issuer’s management specifically


relating to plans, outlook, and competitive position and funding policies. Plant visits are made to gain a better understanding of the issuer’s production process, make an assessment of the state of equipment and main facilities, evaluate the quality of technical personnel and form an opinion on the key variables that influence the level, quality and cost of production. These visits also help in assessing the progress of projects under implementation. After completing the analysis, a Rating Report is prepared, which is presented to the CRAB Rating Committee. The Rating Team also makes a presentation on the issuer’s business and management. The Rating Committee is the final authority for assigning Ratings. Issuer mandates rating

Analysis Analysis and and evaluation evaluation by by CRAB CRAB Analysts Analysts

Appeal by issuer and reappraisal (if appropriate)

assignment Preliminary discussion between Issuer and rating team of CRAB

to CRAB

Rating Rating team team presents presents preliminary preliminary rating rating report report to to internal internal

Announcement of rating

committee committee Issuer prepares/ submits required data requested by rating team

Rating Rating committee committee

Publication of Credit Analysis Report

meeting meeting Additional information gathering, visits and meeting with Issuer and management

Notification to

On going surveillance/ formal annual reviews

issuer

Part 2.22 Requirements for Rating •

The Credit Rating Companies Rules 1996 issued by the Securities & Exchange Commission of Bangladesh requires that the following instruments be rated prior to making issuance, and that the information on rating be incorporated in the prospectus of offer documents : Public Offer of all Debt Instruments: Bond, Debenture, Commercial Paper, Structured Finance (Asset/Mortgage Backed Securities), and Preference Shares. Public Issue of shares at a premium Issue of Right Shares of a public company at a premium

• • • •

B. SEC (Asset Backed Security Issue) Rules, 2004 requires that the Credit Rating Report for the asset pools to be securitized be compiled along with the application for consent of the commission for issuance of Asset Backed Securities C. Bangladesh Bank through its circulars requires mandatory credit rating for the followings:

• Initial Public Offerings of all Commercial Banks • Initial Public Offerings of all Non Banking Financial Institutions • Rating of all Commercial Banks on an annual basis with arrangement for continuous surveillance •

D. Office of the Chief Controller of Insurance through its circular requires mandatory rating for the followings:


• •

General Insurance Companies on an annual basis Life Insurance Companies on biennial (once in every two years) basis

The basic objective of rating is to provide an opinion on the relative credit risk (or default risk) associated with the instrument being rated. This in a nutshell includes, estimating the cash generation capacity of the issuer through operations (primary cash flows) vis-à-vis its requirements for servicing obligations over the tenure of the instrument. Additionally, an assessment is also made of the available marketable securities (secondary cash flows), which can be liquidated if required, to supplement the primary cash flows. It may be noted that secondary cash flows have a greater bearing in the short-term ratings, while the long-term ratings are generally entirely based on the adequacy of primary cash flows. All the factors, which have a bearing on future cash generation and claims that require servicing, are considered to assign ratings. These factors can be conceptually classified into business risk and financial risk drivers. A. Business Risk Drivers Industry characteristics Market position Operational efficiency New projects Management quality

B. Financial Risk Drivers Funding policies Financial flexibility

A. Business Risk Drivers 1. Industry Characteristics: This is the most important factor in the credit risk assessment. It is a key determinant of the level and volatility in earnings of any business. Other factors remaining the same, industry risk determines the cap for ratings. Demand factors Drivers & potential Nature of product Nature of demand - seasonal, cyclical Bargaining position of customers

State of competition Existing & expected capacities Intensity of competition Entry barriers for new entrants Exit barriers Threat of substitutes

2. Market position: All the factors influencing the relative competitive position of the issuer are examined in detail. Some of these factors include positioning of the products, perceived quality of products or brand equity, proximity to the markets, distribution network and relationship with the customers. In markets where competitiveness is largely determined by costs, the market position is determined by the unit’s operational efficiency. The result of these factors is reflected in the ability of the issuer to maintain /improve its market share and command differential in pricing. It may be mentioned that the issuers, whose market share is declining, generally do not get favorable long-term ratings.


3. Operational efficiency: In a competitive market, it is critical for any business unit to control its costs at all levels. This assumes greater importance in commodity or "me too " businesses, where low cost producers almost always have an edge. Cost of production to a large extent is influenced by: • • • •

Location of the production unit(s) Access to raw materials Scale of operations Quality of technology

• • •

Level of integration Experience And last but not the least the ability of the unit to efficiently use its resources.

A comparison with the peers is done to determine the relative efficiency of the unit. Some of the indicators for measuring production efficiency are: resource productivity (both assets and manpower), material usage (or input-output ratios) and energy consumption. Collection efficiency and inventory levels are important indicators of both the market position and operational efficiency. 4. New project risks: The scale and nature of new projects can significantly influence the risk profile of any issuer. Unrelated diversifications into new products are invariably assessed in greater detail. The main risks from the new projects are: Time and cost overruns, even non-completion in an extreme case, during construction phase; financing tie-up; operational risks; and market risk. Besides clearly establishing the rationale of new projects, the protective factors that are assessed include: track record of the management in project implementation, experience and quality of the project implementation team, experience and track record of technology supplier, implementation schedule, status of the project, project cost comparisons, financing arrangements, tie-up of raw material sources, composition of operations team and market outlook and plans. 5. Management quality: The importance of this factor cannot be overemphasized. When the business conditions are adverse, it is the strength of management that provides resilience. A detailed discussion is held with the management to understand its objectives, plans & strategies, competitive position and views about the last performance and future outlook of the business. B. Financial Risk Drivers Labor relations, track record of meeting promises specifically relating to returns and project implementation, performance of "group" companies, transactions with the "group" companies etc. 1. Funding policies: This determines the level of financial risk. Management’s views on its funding policies are discussed in detail. These discussions are generally focused on the following issues: • •

Future funding requirements Level of leveraging


• • • • •

Views on retaining shareholding control Target returns for shareholders Views on interest rates Currency exposures including policies to control the currency risk Asset-liability tenure matching.

These sources include: Availability of liquid investments, unutilized lines of credit, financial strength of group companies, market reputation, relationship with financial institutions and banks, investor’s perceptions and experience of tapping funds from different sources. Generally financial flexibility factor facilitates determination of the relative strength within a rating category (i.e., + or - prefix with the rating) and has a greater bearing on the short-term ratings. Past financial performance: The impact of the various risk drivers is reflected in the actual performance of the issuer. Thus while the focus of rating exercise is to be determined the future cash flow adequacy for servicing debt obligations, a detailed review of the past financial statements is critical for better understanding of the influence of all the business and financial risk factors. Accounting Quality: Consistent and fair accounting policies are a pre-requisite for financial evaluation and peer group comparisons. It may be mentioned that accounting quality is also an important indicator of the management quality. Rating analysts review the accounting policies, notes to the accounts and auditors comments in detail. Where necessary, rating analysts adjust the financial statements to reflect the correct position. Profitability: A traditional indicator of success or failure of any business endeavor has been its ability to add value to its wealth or generate profits. A few important indicators are, trends in: • Return on capital employed • Return on net worth • Gross operating margins Higher profitability implies greater cushion to debt holders. Profitability also determines the market perception, which has a bearing on the support of shareholders and other lenders. This support can be an important factor during stress. Liquidity position: The indicators of liquidity position are, the levels of: • Inventory • Receivables • Payables


The state of competition, issuer’s market position & policies, relationship with customers and suppliers are the important factors that impact the above levels. Comparison with peers on these indicators help to determine the relative position of the issuer in the industry. The funding profile with respect to matching of assets -liability tenures also has an important bearing on the liquidity position.

Part 2.23 Rating Process:

• •

Rating is an interactive process with a prospective approach. It involves a series of steps. The main steps are described as follows:

Rating Request:

Ratings in CRAB are usually initiated on formal request (or Mandate) from the prospective Issuer. An undertaking is also obtained on a Taka 150 non-judicial Stamp Paper before commencement of a Rating assignment; which spells out the terms and conditions of the engagement of credit rating agency.

Rating Team:

The Rating 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. The team is usually led by the lead analyst with adequate knowledge of the relevant industry / instrument to be Rated

Role of the Lead Analyst:

The lead analyst shall arrange to finalize the Rating report and send the same to the Rating Committee members. The lead analyst shall arrange to make a presentation before the Rating Committee. The lead analyst will make sure that all the relevant and material issues that may have an impact on the credit quality of the issuer (including, but not limited to those which are related to the programs being Rated) are presented before the Rating Committee for discussion. The lead analyst will ensure communication of the Rating decision to the Issuer and initiate all the necessary actions consequent to the reaction of the issuer depending on the circumstances.

• • • •

Information Requirements:

Issuers are provided with a list of information requirements and broad framework for discussions. These


requirements are derived from the experience of the Issuers business and broadly conform to all the aspects, which have a bearing on the Rating. •

Secondary Information:

CRAB draws on the secondary sources of information including its own in-house research and information obtained through meetings with the Issuers’ bankers, auditors, customers and suppliers among many other relevant market participants. CRAB 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 changes in industry structure, sector outlook, global trends and government policies, etc. for the industry.

Management Meetings and plant visits:

Rating involves assessment of number of qualitative factors with a view to estimate the future earnings prospects of the Issuer. This requires intensive interactions with the Issuers’ management specifically with a view to understanding the business plans, future outlook, competitive position and funding policies, etc.

Other Meetings:

The CRAB analyst team may also decide to meet the auditors (accounting policies followed, quality of internal controls, standard of disclosures, etc.), bankers / lenders (relationship, reputation, dealings in the past in respect of timeliness of servicing obligations) lawyers (if there are major litigations pending which may have serious impact on credit quality), trade union leaders (if industrial relations is a sensitive issue), key functional executives as well as a few investors, customers and suppliers, depending upon the circumstances to get a direct feedback from different stakeholder.

• •

Meeting with the Issuers’ CEO /CFO: This would be a very important meeting (usually, the last meeting) when the Rating team would discuss all the critical issues / findings that may impact the Rating decision with the CEO / CFO of the Issuer (in the absence of CEO / CFO, with a senior executive nominated by the Issuer for this purpose).

Internal Review Committee Meeting

Once the draft report is prepared by the Analysts team, it is placed before the Internal Review Committee Meeting. The committee comprise of senior analysts. The committee reviews the draft rating report and analysis made by the analysts. Committee also reviews the due diligence, documents, meetings, site visits etc.

Rating Committee Meeting:

The authority for assigning Ratings is vested in the Rating Committee of CRAB. The Rating reports are sent by the analyst team in advance to the Rating Committee members. A presentation about the Issuers business and the management is made by the Rating team to the Rating Committee at the meeting. All the key issues are identified and discussed at length during the meetings and all relevant issues, which influence the Rating, are considered. The differences if any arise during the discussion are taken note of. Finally, a Rating is assigned either by a consensus or by majority votes.

Surveillance:

It is obligatory on the part of CRAB to monitor Accepted Ratings (including the Ratings treated as Deemed Acceptance) over the tenure of the Rated instrument or till any amount is outstanding under the


programme(s) Rated. The Issuer is bound by the agreement to provide information to CRAB to facilitate such monitoring. In case the Issuer do not co-operate by way of providing information, etc, for the purpose of surveillance, CRAB may on its own carry out the surveillance on best efforts basis based on the available information and possible interactions after giving the Issuer adequate notice requesting him to co-operate. The Ratings are generally reviewed every year, unless the circumstances of the case warrant an earlier review due to changes in circumstances or major developments that were not anticipated / factored in the Rating decision. •

The Ratings may be Upgraded, Downgraded or retained after the surveillance. The CEO, at his sole discretion, may give one opportunity to the Issuer to represent his case if he is not satisfied with the Rating decision after the surveillance process. However, the Issuer would not have any option of not accepting the Rating after the surveillance.


Part 2.24 Rating Fee:

Fee For Corporate Entity Rating: Category-I: Corporate with asset size Tk . 75 crore and above:

Initial Rating Fee (Year 1)

Annual Review (From Year 2 onwards)

Tk. 5.50 Lac

Tk . 4.00 Lac

Category-II: Corporate with asset size less than 75 crore and more than 40 crore:

Initial Rating Fee (Year 1)

Annual Review (From Year 2 onwards)

Tk. 4.50 Lac

Tk. 3.00 Lac

Category-III: Corporate with asset size less than 40 crore but more than 20 crore:

Initial Rating Fee (Year 1)

Annual Review (From Year 2 onwards)

Tk. 2.50 Lac

Tk . 2.00 Lac

Category-V: Corporate with asset size less than 10 crore :

Initial Rating Fee (Year 1)

Annual Review (From Year 2 onwards)

Tk. 2.00 Lac

Tk. 1.50 Lac

*Assets= Fixed Assets + Current Assets Fee for Project Rating: Project Loan above 25 crore :

Initial Rating Fee (Year 1)

Annual Review (From Year 2 onwards)

0.08% of the proposed external financing.

0.06% of the proposed external financing.

Project Loan below 25 crore :


Initial Rating Fee (Year 1)

Annual Review (From Year 2 onwards)

Tk. 2.00 Lac.

Tk. 1.50 Lac


PART 2.25- THE CREDIT RATING PROCESS OF CRAB IN VARIOUS SECTORS: Part 2.26 BASEL-II Compliances: International Convergence of Capital Management and Capital Standard, popularly known as BASEL-II is being implemented globally. The Bangladesh Bank has also the plan to implement the same within a given the frame. Under BASLE-II banks will be required to comply with a new set of risk management system covering its credit risk, operational risk and disclosure management. All these warrant to bank to bring the existing system as close to BASEL requirement as possible so that the bank do not face any major change in the system in the system abruptly. CRA examines the current status and management policy to bring the bank to a position within a time horizon. BASEL-II emphasized on the adequate disclosure of banks risk management system, which is also considered by CRA in the evaluation process. Part 2.27 Why Bank Need Credit Rating Bank rating is arising from the fact that the banks and financial institutions are highly leveraged. Banks in Bangladesh with an average owner’s equity of 5% are undertaking a liability of 95% with 100% guarantees to repay in timely manner. The funds collected through the above guarantees are invested with 100% risk to earn a net interest margin of 2% to 4% through undertaking high Credit Risk, Operational Risk and Market Risk. The above situation puts the banks and financial institutions in such a vulnerable position that any mistake in the process may put the bank in a distress situation. Keeping in view the above globally banks are managed through a very cautious Asset Liability Management System (ALM). The objective of Commercial Bank Rating is to provide an opinion on the relative inherent quality of the Equity Instrument contemplated to be issued at Public Offer. The rating opinion is reflected by the earnings prospects, risk and financial strength, associated with the specific bank. Rating of Commercial Bank for the purpose of Public Offer does not predict the future market price of the share; rather it rates the fundamentals of a bank, which ultimately act as important inputs in the price behavior of the share of the bank over the medium and long term perspectives. In the short term, Commercial Bank Rating facilitates the reconciliation of the market attitude with respect to the share of company to the long-term fundamentals as reflected by the equity rating. The benefits of Credit Rating to Issuers/Companies are: • Rating of a Public Offer issued by Commercial Bank would ensure due compliance with the relevant legal regulatory provision of the Securities & Exchange Commission (SEC) of Bangladesh. • Rating would facilitate the issuer bank to effect of credibility among potential investors. • CRA opinion would help the issuer company to broaden the market for their equity. As ‘name recognition’ is replaced by objective opinions, the issuer company may access the equity market more comfortably. • Equity Instrument Rating may help in establishing issuer’ access to the equity market even when the market price of listed equities is relatively unfavorable in the prevailing market conditions. • Rating would facilitate a bank with fundamental strength an extended level of confidence from the depositors. • CRA rating would provide the Commercial Bank with an in depth analysis of the overall position and performance of the bank in comparison with its competitors in the peer group and give a guideline for areas of improvement. • Commercial Bank Rating would give market participants timely access to unbiased, objective, independent, expert, professional opinion on the equity quality in a user friendly manner that may be relied upon for investment decisions.


• Equity Instrument Rating would effect significant contribution towards developing the stock market investor confidence and enhancing the quality and perfection of the securities markets, through provision of credible information for guidance of institutional and individual investors. Part 2.28- The credit rating process for Bank: Commercial Bank Rating Criteria: CRAB uses a comprehensive methodology for credit rating of commercial banks developed in collaboration with its technical collaboration partner ICRA Ltd of India. The methodology addresses the international standards for credit rating of Commercial banks and incorporates the regulatory framework in Bangladesh. The major factors considered in CRAB’s rating analysis are described below: QUANTITATIVE FACTORS: ANTITATIVE FACTORS The starting point in reaching a rating decision is a detailed review of key measures of financial performance and stability: Capital Adequacy Capital Adequacy is a measure of the degree to which the bank’s capital is available to mitigate the stress of possible losses. CRAB examines the conformity of the bank to the Bangladesh Bank guidelines on Capital Adequacy ratio. Asset Quality Asset Quality review assesses the quality of the bank’s overall investment portfolio and includes a sector by sector analysis of the investment and guarantee portfolio, as well as inter-bank exposures. The historical recovery rate of annual demands of principal and profit and the bank’s experience of investment losses and write off provisions are studied. The percentage of assets classified into standard, substandard, doubtful or loss is examined closely. The portfolio diversification and exposure to troubled industries/areas is evaluated to determine the extent of potential losses. In addition, the bank’s own credit risk norms are examined. Funding and leverage The funding mix determines the leverage and the cost of capital. One of CRAB’s principal aims in bank analysis is to assess the institution’s ability to finance itself in times of stress. CRAB examines the composition of deposits in terms of short term or long term, domestic or foreign currency and also the composition of currencies. The volatility, growth and shift in the composition of the funding pattern are also studied. Overall gearing, profit coverage and their trends are taken as measures of financial risk arising as a result of funding decision. Liquidity Liquidity is often the proximate cause of bank failure, while, strong liquidity can help even an otherwise weak institution to remain adequately funded during difficult times. CRAB determines the maximum stress which the bank is likely to face and evaluates the internal and external sources available to meet this. Factors examined are the credit deposit ratio, the maturity matching of assets and liabilities, proportion of liquid assets to total assets and the degree to which core assets that are illiquid are funded by core liabilities. The short term external funding sources in the form of refinance facilities from Bangladesh Bank and the inter-bank borrowing limits available are considered. The bank’s CRR and SLR investments are important sources of reserve liquidity. Credit Rating Agency of Bangladesh Ltd


Earnings quality Earnings quality reviews cover the performance and risk assessment of each business area- the investment portfolio, guarantees and forex & treasury operations and non fund based activities. CRAB focuses on the strength of each major business and it’s earning prospects. The main indicators used to measure profitability are return on assets, spreads, the expense ratios and the earnings growth rate. Evaluation of quantitative factors is done, not only of the absolute numbers and ratios, but their volatility and trends as well. The attempt is to determine core, recurring measures of performance. CRAB also examines how the bank’s performance on each of the above discussed parameters is, compared to its peers. Detailed inter-firm analysis is done to determine the relative strengths and weaknesses of the bank in its present operating environment and any impact on it, in future. QUALITATIVE FACTORS: Sensitivity to Market Risk The sensitivity test of a bank addresses the degree to which changes in profit rates, foreign exchange rates, commodity prices or equity prices can adversely affect a financial institution's earnings or capital. For most institutions, market risk primarily reflects exposures to changes in profit rates. (An institution's ability to monitor and manage its market risk is also assessed in the qualitative risk management area) QUALITATIVE FACTORS Some of the qualitative factors that are deemed critical in the rating process are: Ownership An assessment of ownership pattern and shareholder support in a crisis is significant. In case of public sector banks, the willingness of the government to support the bank is an important consideration. Management quality The composition of the board, top management and the organizational structure of the bank are considered. The bank’s strategic objectives and initiatives in the context of resources available, its ability to identify opportunities and track record in managing stress situations are taken as indicators of managerial competence. CRAB analyses the bank’s budgeting process and cost control in terms of their effectiveness. The adequacy of the information systems used by the management is evaluated in terms of quality and timeliness of the information made available to bank managers. CRAB focuses on the modern banking practices and systems, degree of computerization, capabilities of senior management, personnel policies and extent of delegation of powers. Risk Management Credit risk management is evaluated through the appraisal, monitoring and recovery systems and the internal prudential lending norms of the bank. The bank’s balance sheet is examined from the perspective of profit rate sensitivity and foreign exchange rate risk. Liquidity risk arises due to differing maturity of assets and liabilities and Profit rate risk appears because of mismatch between the floating and fixed rate assets and liabilities. CRAB also assesses the extent to which the bank has assets denominated in one currency with liabilities denominated in another currency. Compliance with statutory requirements CRAB examines the track record of the bank in complying with SLR/CRR and priority sector lending norms as specified by Bangladesh Bank.


Accounting Quality Rating relies heavily on audited data. Policies for income recognition, provisioning and valuation of investments are examined. Suitable adjustments to reported figures are made for consistency of evaluation and meaningful interpretation. Size and Market Presence The fund base and branch network of the bank are taken as important indicators of strength. In a fast changing environment, a large bank can meet the competitive challenges from other financial intermediaries due to its economies of scale and wider reach. Also if the bank represents a substantial percentage of the banking sector, its Failure would cause severe disruptions for the country as a whole and it is thus likely to obtain government support in times of distress. All relevant quantitative and qualitative factors are considered together, as relative Weakness in one area of the bank’s performance may be more than adequately compensated for by strengths elsewhere. However, the weights assigned to the factors are different for Short Term Ratings and Long Term Ratings. The intention of long term ratings is to look over a business cycle and not adjust ratings frequently for what appear to be short term performance aberration. The quality of the management and the competitiveness of the bank are of greater importance in long term rating decisions. The rating process is ultimately a search for the fundamentals and the probabilities for change in the fundamentals. The assessment of management quality, the bank’s operating environment and its role in the nation’s financial system is used to interpret current data and to forecast how well the bank is positioned in the future. The final rating decision is made by the Rating Committee after a thorough analysis of the bank’s position over the time with regard to business fundamentals. LONGTERM – COMMERCIAL BANKS ENTITY RATING AAA (Triple A): Have extremely strong capacity to meet financial commitments, maintains highest quality, with minimal credit risk. AA1, AA2, AA3* (Double A): Have very strong capacity to meet financial commitments, maintains very high quality, with very low credit risk. A1, A2, A3 (Single A): Have strong capacity to meet financial commitments, maintains high quality, with low credit risk, but susceptible to adverse changes in circumstances and economic conditions. BBB1, BBB2, BBB3 (Triple B): Have adequate capacity to meet financial commitments but are susceptible to moderate credit risk. Adverse changes in circumstances and economic conditions are more likely to impact capacity to meet financial commitments. BB1, BB2, BB3 (Double B): Have inadequate capacity to meet financial commitments and possess substantial credit risk, with major ongoing uncertainties and exposure to adverse business, financial, or economic conditions. B1, B2, B3 (Single B): Have weak capacity to meet financial commitments and are subject to high credit risk. Currently meeting the financial commitments, but adverse business, financial, or economic conditions are likely to impair capacity to meet obligations. CCC1, CCC2, CCC3 (Triple C): Currently vulnerable, and are dependent upon favorable business, financial, and economic conditions to meet financial commitments. Have very weak standing and are subject to very high credit risk.


CC (Double C): Currently highly vulnerable, highly speculative and are very near to default, with some prospect of recovery. C (Single C): Currently very highly vulnerable to non-payment, may be subject of bankruptcy petition or similar action, though have not experienced payment default. C is typically in default, with little prospect for recovery. D Default. 'D' rating also will be used upon the filing of bankruptcy petition or similar action if payments on an obligation are jeopardized. *Note: CRAB appends numerical modifiers 1, 2, and 3 to each generic rating classification from AA through CCC. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category. RATING DEFINITION: Commercial Banks ST-1 : Highest Grade. Highest capacity for timely repayment of obligations. ST-2 : High Grade. Strong capacity for timely repayment of obligations. ST-3 : Average Grade. Average capacity for timely repayment of obligations. ST-4: Below Average Grade. Below average capacity for timely repayment of obligations. ST-5 : Inadequate Grade. Inadequate capacity for timely repayment of obligations. ST-6: Lowest Grade. High risk of default or are currently in default. Part 2.29- The credit rating process for manufacturing Cos. CORPORATE RATING CRITERIA CRAB uses a comprehensive methodology for credit rating of corporate entities developed in collaboration with its technical collaboration partner ICRA Ltd of India. The methodology addresses the international standards for credit rating of corporate and incorporates the regulatory framework in Bangladesh. The major factors considered in CRAB’s rating analysis are described below: Industry Risk Analysis Analysis of industry risk focuses on the prospects of the industry and the competitive factors influencing it. The industry environment is assessed to determine the degree of operating risk faced by the company in a given business. Investment plans of the major players in the industry demand supply factors, price trends, changes in technology, international/domestic competitive factors, entry barriers, capital intensity, business cycles etc. are key ingredients of industry risk. Rating also takes into account economy wide factors which have a bearing on the industry under consideration. The strategic natures of the industry in the prevailing policy environment, regulatory oversight governing industries etc are also analyzed. Business Risk Analysis The position of the Company within the industry is then analyzed. The key areas considered in assessment of business risk are as follows: Diversification For companies that operate in several industries, each major business segment is analyzed separately. The contribution of each business segment to the company’s overall profitability is assessed. While diversification results in better sustainability in cash flows, the analysis specifically looks into the suitability and adequacy of management structure to operate the diversification. Analysis also considers the


Forward and backward linkages required for the diversified operations. Seasonality and Cyclicality Some industries are cyclical in nature with their performance varying through the economic cycle. Some industries are seen to exhibit seasonality in sales or production. The analyses aim to be stable across seasons and economic cycles and are adjusted considering the long term fundamentals. Scale of Operation Small size presents a significant hurdle in getting higher ratings commensurate with a company’s financials. Presence in selected market segments, limited access to funds leading to lack of financial Flexibility etc., result in lower protection of margins when faced with adverse developments in business areas. Large firms, on the other hand, have higher sustaining power, even during troubled times. Cost Structure The cost factors and efficiency parameters of existing operations are assessed in respect of expenditure levels required to maintain its existing operating efficiencies as well as to improve its efficiency parameters in a competitive scenario. Nature of technology may also influence the cost structure. Market share A company’s current market share and the trends in market share in the past are important indicators of the competitive strengths of the company. A sustained leadership position leads to ability to generate cash over the long term. A market leader generally has financial resources to meet competitive pricing challenges. Marketing and distribution arrangements Depending on the nature of the product, the rating analyses the depth and importance of the marketing and distribution of the company. For example, companies in FMCG sector require an extensive marketing And distribution network and rating gives high importance to the same when analyzing companies in those industries. Strategy & Financial Policies The company’s business plans, mission, policies and future strategies in relation to the general industry scenario are assessed. An important factor is assessment of the management’s ability to look into the future and its strategies and policies to tackle emerging challenges. The financial policies of the sponsors and management regarding financing its capital expenditure and working capital requirement are analyzed. Operating Efficiency In a competitive market, it is critical for any business unit to control its costs at all levels. This assumes greater importance in commodity or me-too” businesses, where low cost producers almost always have an edge. Cost of production to a large extent is influenced by: # Location of the production unit(s) # Access to raw materials # Scale of operations # State of technology


# Level of integration # Experience of operating personnel And last but not the least, the ability of the unit to efficiently use its Resources. A comparison with the peers is done to determine the relative efficiency of the unit. Some of the indicators for measuring production efficiency are: resource productivity (both assets and manpower), material usage (or input-output ratios) and energy consumption. Collection efficiency and inventory levels are important indicators of both the market position and operational efficiency. State of technology is a key to operational efficiency and lower production costs. Analysis of technology will also cover probability of obsolescence and threat of new technology. Market position All the factors influencing the relative competitive position of the Issuer are examined in detail. Some of these factors include positioning of the products, perceived quality of the products or brand equity, proximity to the markets and distribution network as well as relationship with the customers. Competitiveness is largely determined by costs. The market position is reflected in the ability of the Issuer to maintain /improve its market share and command differential in pricing. It may be mentioned that the Issuers whose market share is declining or expected to decline generally do not get favorable long term Ratings. Financial Strength Financial strength analysis involves evaluation of past and expected future financial performance with emphasis on assessment of adequacy of cash flows towards debt servicing. The analysis is mainly Based on audited accounts of the company although unaudited accounts are noted. A review of accounting quality and adherence to prudential accounting norms are examined for measuring the Company’s performance. Accounting policies relating to depreciation, inventory valuation, income recognition, valuation of investments, provisioning/ write off etc. are given special attention. Prudent disclosures of material events affecting the company are reviewed. Impact of the auditor’s qualifications and comments are quantified and analytical adjustments are made to the accounts, if they are material. The rating team may meet the auditor to understand his comfort level with the accounting records, systems and policies of the company and his assessment of the management of the company. In the process, the rating group also forms an opinion on the quality of the auditor and his firms’ reputation in the market. Off-balance sheet items are factored into the financial analysis and adjustments made to the accounts, wherever necessary. Change of accounting policy in a particular year which results in improved reported performance is analyzed more closely. Financial Ratios Financial ratios are used to make a holistic assessment of financial performance of the company, as also to see the company’s performance compared to its peers within the industry. (i) Growth Ratios: Trends in the growth rates of a company vis-à-vis the industry reflect the company’s ability to sustain its market share, profitability and operating efficiency. In this regard, focus is drawn to growth in income, PBIDT, PAT and assets.


(ii) Profitability Ratios: Capacity of a company to earn profits determines the protection available to the company. Profitability reflects the final result of business operations. Important measures of profitability are PBIDT, Operating and PAT margins, ROAE and ROAA. Profitability ratios are not regarded in isolation but are seen in comparison with those of the competitors and the industry segments in which the company operates. (iii) Leverage and Coverage Ratios: Financial leverage refers to the use of debt finance. While leverage ratios help in assessing the risk arising from the use of debt capital, coverage ratios show the relationship between debt servicing Commitments and the cash flow sources available for meeting these obligations. The ratios considered are: Debt/Equity Ratio, Overall gearing ratio, Interest Coverage, Net cash accruals / Debt and Debt Service Coverage Ratio to measure the degree of leverage used vis-à -vis level of coverage available with the company. (iv) Turnover Ratios: Turnover ratios, also referred to as activity ratios or asset management ratios, measure how efficiently the assets are employed by the firm. These ratios are based on the relationship between the level of activity, Represented by sales or cost of goods sold, and level of various assets, including inventories and fixed assets. (v) Liquidity Ratios: Liquidity ratios such as current ratio, quick ratio etc. are broad indicators of liquidity level and are important ratios for rating short term instruments. Cash flow statements are also important for liquidity analysis. Cash flows Interest and principal obligations are required to be met by cash and hence only a thorough analysis of cash flow statements would reveal the level of debt servicing capability of a company. Cash flow analysis forms an important part of credit rating decisions. Availability of internally generated cash for servicing debt is the most comforting factor for rating decisions as compared to dependence on external sources of cash to cover temporary shortfalls. Cash flow adequacy is viewed by the capability of a company to finance normal capital expenditure, as well as its ability to manage capital expenditure programs as per envisaged plans apart from meeting debt servicing requirements. Financial flexibility Financial flexibility refers to alternative sources of liquidity available to the company as and when required. Company’s contingency plans under various stress scenarios are considered and examined. Ability to access capital markets and other sources of funds whenever a company faces financial crunch is reviewed. Existence of liquid investments, access to lines of credits from strong group concerns to tide over stress situations, ability to sell assets quickly, defer capes etc. are favorably considered.


Validation of projections and sensitivity analysis The projected performance of the company over the life of the instrument is critically examined and assumptions underlying the projections are validated. The critical parameters affecting the industry And the anticipated performances of the industry are identified. Each critical parameter is then stress tested to arrive at the performance of the company in a stress situation. Debt service coverage for each of The scenarios would indicate the capability of the company to service its debt, under each scenario. Management Evaluation Management evaluation is one of the most important factors supporting a company’s credit standing. An assessment of the management’s plan in comparison to those of their industry peers can provide important insights into the company’s ability to sustain its business. Capability of the management to perform under stress provides an added level of comfort. Meetings with the top management of the company are an essential part of the rating process. Track record The track record of the management team is a good indicator for evaluating the performance of the management. Management’s response to key issues/events in the past like liquidity problems, competitive pressures, new project implementation, expansions and diversifications, etc. are assessed. Performance of group companies Interests and capabilities of the group companies belonging to the same management/sponsors give important insights into the management’s capabilities and performance in general. Organizational structure Assessment of the organizational structure would indicate the adequacy of the same in relation to the size of the company and also give an insight on the levels of authority and extent of its delegation to lower levels in the organization. The extent to which the current organizational structure is attuned to management strategy is assessed carefully. Control systems Adequacy of the internal control systems to the size of business is closely examined. Existence of proper accounting records and control systems adds credence to the accounting numbers. Management information system commensurate with the size and nature of business enables the management to stay tuned to the current business environment and take judicious decisions. Personnel policies Personnel policies laid down by the company would critically determine its ability to attract and retain human resources. Incidence of labor strikes/unrest, attrition rates etc., are seen in perspective of nature of business and relative importance of human capital. Corporate Governance The corporate governance practices prevalent in a company reflect the distribution of rights and responsibilities among different participants in the organization such as the Board, management, shareholders and other financial stakeholders, and the rules and procedures laid down and followed for making decisions on corporate affairs. The emphasis is on company’s business practices and


quality of disclosure standards that address the requirements of the regulator sand are fair and transparent for its financial stakeholders. Security & Relationship Risk Analysis This part is included to identify and assess the relationship history with the financers in term of credit sanctions, limit utilization, repayments, securities etc. SCALES AND DEFINITIONS LONGTERM – CORPORATE ENTITY RATING AAA (Triple A) Companies rated in this category have extremely strong capacity to meet financial commitments. These are judged to be of the highest quality, with minimal credit risk. AA1, AA2, AA3 (Double A)* Companies rated in this category have very strong capacity to meet financial commitments. These are judged to be of very high quality, subject to very low credit risk. A1, A2, A3 (Single A) Companies rated in this category have strong capacity to meet financial commitments, but susceptible to the adverse effects of changes in circumstances and economic conditions. These are judged to be of high quality, subject to low credit risk. BBB1, BBB2, BBB3 (Triple B) Companies rated in this category have adequate capacity to meet financial commitments but more susceptible to adverse economic conditions or changing circumstances. These are subject to moderate credit risk. Possess certain speculative characteristics. BB1, BB2, BB3 (Double B) Companies rated in this category have inadequate capacity to meet financial commitments. Have major ongoing uncertainties and exposure to adverse business, financial, or economic conditions. Have speculative elements, subject to substantial credit risk. B1, B2, B3 (Single B) Companies rated in this category have weak capacity to meet financial commitments. Have speculative elements, subject to high credit risk. CCC1, CCC2, CCC3 (Triple C) Companies rated in this category have very weak capacity to meet financial obligations. Have very weak standing and are subject to very high credit risk. CC (Double C) Companies rated in this category have extremely weak capacity to meet financial obligations. Highly speculative and are likely in, or very near, default, with some prospect of recovery of principal and interest. C (Single C) Companies rated in this category are highly vulnerable to non-payment, have payment arrearages allowed by the terms of the documents, or subject of bankruptcy petition, but have not experienced a payment default. Payments may have been suspended in accordance with the instrument's terms. Typically in default, with little prospect for recovery of principal or interest. D Default. Will also be used upon the filing of a bankruptcy petition or similar action if payments on an obligation are jeopardized. *Note: CRAB appends numerical modifiers 1, 2, and 3 to each generic rating classification from AA through CCC. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category.


Part 2.30- The Process for Financial Institution Rating: CRAB uses a comprehensive methodology for credit rating of FIs developed in collaboration with its technical collaboration partner ICRA Ltd of India. The methodology addresses the international standards for credit rating of financial institutions and incorporates the regulatory framework in Bangladesh. The rating methodology is built around the way NBFIs operate, and is comprehensive in its concept and approach. As in any opinion on credit quality, the credit rating agency’s ratings factor the entire gamut of risks that can possibly affect the operations of a finance company. These risks can be broadly classified under three heads:  Operating Risks  Financial Risks  Management Risks The above risks are packaged into the credit rating agency’s rating scale in a manner that is consistent across time and across different issuers of debt instruments. Thus, an investor is spared the task of a detailed evaluation of the claims made by the company or an analysis of its financial statements, and can instead make an informed investment decision on the basis of the credit ratings. Volatility in Revenues and Expenses The operating risks for a finance company manifest in the form of fluctuations in the income and / or expenses, and consequently, affect the profitability and financial position. Volatility in the revenue stream of the company can arise out of the intrinsic nature of the operation and / or the fluctuations in the economy [which affects the paying capacities of the borrowers]. An increase in the cost of borrowings can temporarily derail the business plan of a finance company, as its margins would be squeezed. Similarly, the revenues from fee-based businesses are also dependent on the underlying business activities, and there are attendant fluctuations in the revenues. Regulatory Risks Since the financial sector is fairly regulated in Bangladesh, a finance company’s operations are governed by the changes in regulation that occur from time to time, some of which can be sudden and unpleasant. The effect of the changes in regulation on the industry and individual companies while assigning its ratings is also evaluated by a credit rating agency. Risk of Administrative Expenses If the proportion of earning assets is low in relation to the expenses, that is, there is insufficient volume of business to spread the fixed costs over, the company runs the risk of not being able to cover its costs. The share of earning assets can decline due to other reasons as well, for example – diversion of funds into other businesses that have a long gestation period, buying up large premises that lock up funds, inefficiency in collection and remittance which increases the idle cash balances, etc. Deterioration in Asset Quality Quality of loans and receivables is a key factor that determines the cash flows and consequently, the debt-servicing ability of a finance company. The loss of income and the need to provide for loan losses can seriously undermine a company’s financial base. Also, even if the loans are not lost cases, a continuous delay brings down the effective yield on loans, and could jeopardize viability. The potential asset quality by analyzing the concentration risks [across borrower segments, industry segments, and relative


size of loan, etc.], by evaluating the appraisal and monitoring systems in place for the kind of business the company is in, and examining the safeguards taken by the company is in, and examining the safeguards taken by the company to ensure that its money comes back, as scheduled, are Evaluated. MAJOR DETERMINANTS OF FINANCIAL RISK Capital Adequacy The capital structure of a finance company confers varying degree of security to its lenders against the risk of going insolvent. Capital adequacy refers to the quantum of shareholders’ funds in the business in relation to the risk-weighted assets that the company has. While there are regulatory minimum limits for this figure, different businesses have different risks depending on a variety of factors such as location of operation, size of clients, competition, etc. which could mandate a higher level of capital adequacy for some of them. Asset Liability Management Money management is the core of the operations of all finance companies, and a critical aspect of this is the proper control on the assets and liabilities, the company is vulnerable to shortage of cash, and needs to take corrective action. There is also the problem of mismatch in the interest rates between the two, and unless the management consciously attempts to make amends, the margins can be affected seriously due to changes in the external environment. Solvency For a company to remain viable, it is vital that it is able to consistently generate a surplus in the long run, after meeting all its operating expenses and cost of funds (including shareholders’ equity). In the long run, it is only the plough-back of surplus earnings that can support increasing quantum of borrowings that fund the company’s growth. In the event of continuous losses or inadequate surplus generation, the company can fall into a debt trap, if it continues to increase its borrowings to fund its growth. Financial Flexibility Financial flexibility refers to the ability of the company to raise financial resources from any source under conditions of financial duress. This ability of a company enables it to dip into its pockets or borrow from lenders who are willing to finance it despite its crunch, and help meet its immediate Obligations. Financial flexibility arises out of the ability of a company:  To borrow from other entities – maybe on the strength of one’s balance sheet, corporate image or the clout of the top management.  To borrow from entities, maybe, in the same group or under the same management.  To utilize undrawn lines of credit or borrowing power.  To liquidate some assets that have been kept for such contingencies. Accounting Quality There are several areas where there is freedom for different companies, and it is necessary to re compute some of the figures to make comparisons with the other companies in the peer group. Management Quality A significant weight age is attached to the quality of the company’s management in its ultimate opinion on credit quality of the company’s debt .In evaluating a management, the credibility of the management’s plans for the company in the backdrop of the economic scenario and the outlook for


the specific company is assessed. To make a judgment on the quality of management, the historical track record of the management in several areas is analyzed, inter alia, [a] in overcoming adversity in operating conditions, such as, a funds crunch, strong competition, sudden deterioration in asset quality, etc. [b] attitude towards the interests of investors and other stakeholders in the company, [c] conformance to regulation and adoption of fair business practices [d] ability to professionalize and delegate decision making with reference to the nature and scale of operations. Evaluation of Systems The systematic and timely flow of correct information, in the form of plans, budgets, targets, management information for review and / or control is the lifeblood of a finance company’s operations. The extent of automation is a reflection of several factors such as the scale of operations, the attitude of The management and the economics of automating the operations. LONGTERM – FINANCIAL INSTITUTIONS ENTITY RATING AAA (Triple A): Have extremely strong capacity to meet financial commitments, maintains highest quality, with minimal credit risk. AA1, AA2, AA3* (Double A): Have very strong capacity to meet financial commitments, maintains very high quality, with very low credit risk. A1, A2, A3 (Single A): Have strong capacity to meet financial commitments, maintains high quality, with low credit risk, but susceptible to adverse changes in circumstances and economic conditions. BBB1, BBB2, BBB3 (Triple B): Have adequate capacity to meet financial commitments but are susceptible to moderate credit risk. Adverse changes in circumstances and economic conditions are more likely to impact capacity to meet financial commitments. BB1, BB2, BB3 (Double B): Have inadequate capacity to meet financial commitments and possess substantial credit risk, with major ongoing uncertainties and exposure to adverse business, financial, or economic conditions. B1, B2, B3 (Single B): Have weak capacity to meet financial commitments and are subject to high credit risk. Currently meeting the financial commitments, but adverse business, financial, or economic conditions are likely to impair capacity to meet obligations. CCC1, CCC2, CCC3 (Triple C): Currently vulnerable, and are dependent upon favorable business, financial, and economic conditions to meet financial commitments. Have very weak standing and are subject to very high credit risk. CC (Double C): Currently highly vulnerable, highly speculative and are very near to default, with some prospect of recovery. C (Single C): Currently very highly vulnerable to non-payment, may be subject of bankruptcy petition or similar action, though have not experienced payment default. C is typically in default, with little prospect for recovery. D Default. 'D' rating also will be used upon the filing of bankruptcy petition or similar action if payments on an obligation are jeopardized.


*Note: CRAB appends numerical modifiers 1, 2, and 3 to each generic rating classification from AA through CCC. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category. RATING DEFINITION: Commercial Banks ST-1 : Highest Grade. Highest capacity for timely repayment of obligations. ST-2 : High Grade. Strong capacity for timely repayment of obligations. ST-3 : Average Grade. Average capacity for timely repayment of obligations. ST-4: Below Average Grade. Below average capacity for timely repayment of obligations. ST-5 : Inadequate Grade. Inadequate capacity for timely repayment of obligations. ST-6: Lowest Grade. High risk of default or are currently in default. Part 2.31- The credit rating process for General Insurance: RATING CRITERIA CRAB’s analyses incorporate an evaluation of the rated company’s current financial position as well as an assessment of how the financial position may change in the future. The rating methodology includes an assessment of both quantitative and qualitative factors based on in depth discussions with the management. CRAB’s insurance ratings generally appoint equal weights on quantitative and qualitative elements, though such weightings can vary in unique circumstances. The evaluation of financial strength and credit quality centers on the ability of the company to meet all of its obligations. The company’s ability to meet its obligations is evaluated under a variety of stress scenarios, not just the “most likely” scenario. In all cases, both the perceived margin of safety, and the stability/volatility of that margin of safety, play important roles in the evaluation of credit quality in the insurance industry. CRAB’s analysis makes a review of the company specifically, as well as the macro trends affecting the industry in general. Rating determinations are based on factors which may vary by company or market. Insurance rating methodology focuses on the following five areas of analysis:  Industry Review  Operational Review  Organizational Review

 Management Review  Financial Review

Industry Review The starting point for rating is a thorough understanding of the industry segment(s) in which the insurer operates. One of the objectives is to judge the extent industry dynamics can impact the ratings levels that individual insurers operating in a given industry segment can achieve. Industry analysis helps analysts to make better judgments on the unique attributes of individual insurers by being able to understand them on a relative as well as absolute basis. The specific evaluation of the non-life insurance industry focuses on:  Level of competition in specific sectors  The basis for competitive advantage in the sector  Barriers to entry and threats of new products  Relative bargaining power of insurers relative to that of buyers and intermediaries  The potential “tail” of losses and ability to make accurate pricing decisions, as well as exposure to large unexpected losses  Regulatory, legal and accounting environment and framework


Generally the non-life is considered among the riskier insurance industry segments compared to life, health, or financial guarantee insurance. This reflects the volatility of year-to-year results, intense competition in most sectors, challenges in predicting losses for products with long reporting and claims settlement “tails”, and exposures to large losses such as property catastrophes. Positively, nonlife insurers face limited competition from outside the industry. Further, the demand for a number of products is supported by third party requirements that individuals and companies carry certain types of insurance. Competition in most sectors has been intense and at times irrational. Ambitious growth plans have often led to “buying” of market share. Operational Review Operational review focuses on a given company’s unique competitive strengths and weaknesses, operating strategies, and business mix. The analysis focuses on both the historical and current business position, and how it is expected to change over time. Operational analysis is among the most critical parts of its ratings review. Companies that have strong balance sheets and acceptable risk exposures can provide near-term financial strength. However, for high levels of credit quality and financial strength to be maintained over the long-term, the company must exhibit favorable operating characteristics. In fact, at the highest end of the rating scale, at which solvency risks are generally very low, differences in the operating profile of individual companies are typically the most influential ratings factor. Included in CRAB’s operational review is an evaluation of:  Underwriting expertise and market knowledge  Distribution capabilities and mix  Classes of business and changes in mix  Market share and growth  Brand name recognition and franchise value

 Expense efficiencies and operational scale  Product and geographical mix  Unique product offerings available through specialized underwriting capabilities  Administrative and technological capabilities

The operational review includes a significant degree of qualitative judgment. There is a delicate balance that needs to be maintained between attaining growth and market share, and maintaining underwriting discipline. Since non-life insurers do not know their largest cost – loss and loss adjustment expenses – at the time policies are sold, insurers need to exercise extra care when growing in a competitive environment. Thus, CRAB places underwriting expertise and market knowledge as the most important operational attributes of a highly rated non-life insurer. Organizational Review Due to the high level of solvency regulation within the insurance industry, legal organizational structure can have a significant impact on capital management, cash flows and the overall credit quality of the parent and individually rated insurance company subsidiaries. The analysis evaluates the company on a free-standing basis. In specific cases, it makes Adjustments based on affiliate relationships. These adjustments, which can be significant, are affected by the following:  Parent financial strength and financial flexibility  Upstream dividend requirements, and availability of parent capital contributions  Potential need to divert capital to support underperforming affiliates

 Business synergies with parent or affiliates  Strengths and weaknesses of subsidiary companies  Formal guarantees or support agreements; track record of affiliate support

Management Review One of the most critical aspects of CRAB’s rating process is the level of confidence we develop in the management team and its stated strategies. The ability of management to establish a “performance-


based” culture, and have in place an appropriate risk/reward system, is a key determinant to overall success. Our specific evaluation of management focuses on the following:  Strategic vision  Appetite for risk  Credibility and track record for meeting expectations

 Controls and risk management capabilities  Depth, breadth, and succession plans  Accomplishments of key executives

Financial Review The financial review includes the calculation of numerous financial ratios and other quantitative measurements. These are evaluated based on industry norms, specific rating benchmarks, prior time periods and expectations specific to the rated entity. Though the financial review is largely a quantitative exercise, the interpretation of the results and weighing them into the final rating includes significant elements of subjectivity and qualitative judgment. Since capital & surplus plays an important role in the financial ratio analysis, CRAB makes adjustments to a company’s reported capital & surplus in order to more accurately reflect ‘true’ levels of capitalization and to provide better comparability in its financial analysis across international boundaries. Adjustments made to a company’s reported capital & surplus include the addition of non-specific liability items such as contingency, catastrophe and equalization reserves. In addition, capital & surplus is adjusted to reflect the difference between the net market value and book value of investments where a company reports investments at book value. The adjustment of capital & surplus for unrealized gains/losses which are not reflected in a Company’s balance sheet is a very important feature of financial analysis as these values can be material and have a significant impact on many of the key quantitative financial tests measuring leverage and liquidity. All audited and regulatory filings are examined. In addition, financial statements prepared using other internationally accepted accounting principles are considered, as are unaudited financial statements, management reports, actuarial evaluations and company projections are assessed when available. The analysis always tries to understand major differences in reported results under different forms of accounting. The financial review is broken into seven main segments:  Underwriting quality  Profitability  Investments and liquidity  Reinsurance utilization

 Loss reserve adequacy  Capital adequacy  Financial flexibility

Underwriting Quality The evaluation of underwriting quality, especially for insurers in higher risk classes of business, is the first part of the financial review and in many ways the most important. In conducting its review, CRAB recognizes that the need for sophisticated underwriting processes can vary dramatically by class of business. CRAB’s goal is to judge the overall health of the book of business, and management understands of its risks and ability to control them. Key areas considered include:  Underwriting expertise in each class of business  Targeted pricing margins including impact of investment income on pricing decisions  Actuarial pricing credibility  Appropriate style of underwriting based on nature of risks (i.e. individually underwritten, template underwritten, etc.)  Pricing flexibility given competitive and regulatory environment  Exposure to large losses such as catastrophes  Balance of premium growth and underwriting discipline  Controls over any third party underwriters, such as managing general agents  Claims management and expertise


 Expense efficiencies, and impact of ceding commissions on expense ratios The underwriting performance is measured using two common ratios – the loss ratio and the expense ratio. To properly interpret these ratios, CRAB considers the company’s business mix, pricing strategy, accounting practices, distribution approach and reserving approach. These ratios are approached for the company as a whole, and by product and market segment. The analysis also looks at ceded reinsurance, as well as on a calendar and accident year basis. It also evaluates underwriting quality in the context of growth in premiums and revenues. It tries to understand how premium growth is influenced by changes in pricing versus growth in exposures, and generally prefers to see reasonably steady, even growth trends, and is concerned by both excessive growth and negative growth. Growth is evaluated in the context of market conditions and strategic initiatives of the insurer. Profitability The focus of analysis of profitability is to understand the sources of profits, the level of profits on both and absolute and relative basis and potential variability in profitability. Profits for general insurers are sourced from two primary functional areas -- underwriting and investment income. As indicated above, profits from underwriting are generated when operating revenues (generally premiums) exceed the sum of losses and administrative expenses. The underwriting margin, and its volatility, generally correlates with the level of risk that is being assumed. Profits derived from investments can take the form of interest, dividends and capital gains and can vary as to their taxable nature. The level of investment earnings is dictated by the investment allocation strategy and the quality of management. Like underwriting income, investment returns and their volatility are also correlated with the level of risk assumed.The analysis measures overall profitability (underwriting and investing) by calculating the company’s operating ratio, which is the combined ratio less the investment income ratio (investment income divided by premiums earned). Operating margin is evaluated on a consolidated basis and by major product and market. To further understand the quality of earnings, evaluates the diversification of earnings, including the balance by market, product, and regulatory jurisdiction. In general, earnings that are well diversified tend to be less volatile. The analysis also calculates the following standard profitability ratios: return on assets (ROA), return on revenue (ROR), and return on equity and surplus (ROE and ROS). Investments/Liquidity The analysis of the investment portfolio focuses on credit risk, market risk, liquidity and historical performance. The investment portfolio is evaluated in the context of the liabilities based on the matching principle, with recognition, however, that most non-life insurers do not match to the extent of their life counterparts. As part of CRAB’s analysis, the company’s investment guidelines and management controls are also evaluated to understand how the investment portfolio may change over time. CRAB examines credit risk by looking at the company’s exposure to higher risk investments relative to the total investment portfolio and capital base. Overall diversification of the investment portfolio by major asset class and industry sector is also evaluated to identify any concentration issues. Market risk is evaluated to identify potential changes in asset valuation due to a change in market conditions, including the equity markets, real estate markets and the interest rate environment. Equity securities are also evaluated as to diversity and risk profile, and the impact on the volatility of capital levels is considered. Historical investment performance is evaluated to determine how well the company’s investment strategies are executed. CRAB examines the company’s investment yield, total return, duration and maturity structure, and historical default experience. Volatility of investment valuations is considered in the context of both book value and underlying market (liquidation) values. In short-tail insurance sectors, liquidity is particularly important. CRAB judges liquidity based on the marketability of the investments. The manner in which the company values its assets on the balance sheet is also closely examined. For classes exposed to catastrophic loss, CRAB reviews how an insurer would plan to raise sufficient liquidity to fund claim costs. CRAB evaluates trends in operating and underwriting cash flows to judge liquidity at the operating company level. It also considers cash flows in the context of future levels of investment income generated by a shrinking or growing portfolio.


Reinsurance Utilization In assessing an insurer’s use of reinsurance, the analysis tries to determine if capital is adequately protected from large loss exposures, and to judge if the ceding company’s overall operating risks have been reduced or heightened. Further, CRAB also looks for cases in which financial reinsurance is being used to hide or delay the reporting of emerging problems that may ultimately negatively impact performance or solvency. In the traditional sense, reinsurance is used as a defensive tool to lay off risks that the ceding company does not want to expose to its earnings or capital. When reinsurance is used defensively, CRAB’s goal is to gain comfort that:  Sufficient amounts and types of reinsurance are being purchased to limit net loss exposures given the unique characteristics of the book  Reinsurance is available when needed  The cost of purchasing reinsurance does not excessively drive down the ceding company’s profitability to inadequate levels, and weaken its competitive pricing posture  The financial strength of re-insurers is strong, limiting the risk of uncollectible balances due to insolvency of the re-insurer.  Exposure to possible collection disputes with troubled or healthy re-insurers is not excessive Loss Reserve Adequacy The most challenging area in analyzing a non-life insurer, and the area most susceptible to analytical error, is the evaluation of loss reserve adequacy. That said, losses resulting from strengthening of reserves for previously undetected deficiencies (i.e. adverse reserve development) have been the most common direct cause of insolvency. Thus, loss reserve adequacy is a critical part of the financial review, and a demonstrated ability to maintain an adequate reserve position is a crucial characteristic for a highly rated insurer. The greatest challenge in assessing loss reserve adequacy is that the data available to conduct the review, be it the information available from statutory returns, or loss development triangles available from management as used for internal analysis, are extremely difficult to interpret. Trends observed from this data can be influenced by a multitude of causes, including changes in business mix, underwriting practices, claims management, reinsurance arrangements, policy terms and other factors, making the ability to draw solid conclusions very difficult. While the analysis of reserve adequacy includes a robust quantitative element, much of the reserve review is qualitative in nature. Accordingly, our review focuses on the following :  Statistical analysis of statutory filing data or other quantitative data  Historical track record in establishing adequate reserves  Management’s reserving targets relative to the point estimate on the actuarial range (high, low, middle)  Key reserving assumptions  Management’s propensity to reflect expected future improvements (such as claim handling enhancements designed to lower claim costs) in current reserves before “proven”  Speed at which negative trends in frequency or severity are reflected in reserves  General market and competitive pricing environment, and propensity of management to carry weaker reserves during down cycles  Use of discounting, financial reinsurance or accounting techniques that reduce carried reserves  Comparison of company loss development trends relative to industry and peers There is significant overlap in qualitative analysis of underwriting quality and reserve adequacy, as the two generally go hand in hand. Most insurers with lax underwriting standards will also have ineffective reserving standards, and vice versa. Also, experience on prior years’ business influences pricing targets on current business. Inadequate reserving can thus result in poor pricing decisions on current and future business. The evaluation of capital adequacy and profitability are also closely linked with its assessment of reserve adequacy. Reserve deficiencies lead to an overstatement of both historical profits (often over a multi-year period) and capitalization.


Capital Adequacy CRAB’s analysis of capital adequacy first focuses on the level and quality of the insurer’s statutory capital position at the operating company level. Capital adequacy is evaluated on a legal entity basis and on a consolidated statutory basis in the case of a group. The review incorporates both risk-based and “traditional” measures. The analysis evaluates the level of capital in relation to a company’s risk exposures, including investments, underwriting, business and reinsurance. Future capital needs based on business growth and other factors are also considered in analysis. It calculates operating leverage ratios on a gross, net and ceded basis. In evaluating the quality of the capital position, analysis considers reserve adequacy, asset valuation, goodwill, accounting practices, financial and other reinsurance arrangements, and other off-balance sheet exposures (such as guarantee fund assessments). Financial Flexibility Financial flexibility, or the company’s ability to access internal and external capital sources, is an important ratings factor. In good times, the ability to access capital to support growth is critical to maximizing the franchise value while maintaining capital adequacy. In bad times, maintaining the confidence of the capital markets and lenders can prove critical in allowing a company to avoid problems such as an inability to refinance maturing debt. Financial flexibility is derived first from the overall quality and reputation of the company as reflected in all of the ratings factors discussed throughout this report. However, financial flexibility is also strongly linked to the company’s financial leverage, debt service coverage and liquidity. CRAB uses traditional balance sheet measures of financial leverage including the ratios of debt to equity, debt plus trust preferred to equity, debt to total capitalization, debt plus trust preferred to total capitalization, and double leverage. If necessary, these balance sheet measures are adjusted to take into account “quality” of capital issues. The debt maturity structure is also evaluated to determine the amount and timing of debt repayment (i.e., refinancing risk). In general, CRAB believes that an appropriate mix of short-term and long-term debt is that which is consistent with its intended use (matching principle). With regard to short-term debt, CRAB expects companies to maintain backup bank facilities to cover short-term disruptions in the commercial paper markets. With regard to lines of credit and other bank facilities, analysis reviews each company’s bank agreements, with a special emphasis on the facility’s tenor, financial covenants, and any material adverse change language. After determining the levels of funds both actually provided to and available to the holding company, CRAB will determine the debt service coverage profile of the organization. CRAB calculates various interest and fixed charge coverage ratios based on operating earnings, cash flow and statutory dividends, as well as various other methods.  LONGTERM – GENERAL INSURANCE COMPANIES ENTITY RATING AAA (Triple A): Have EXTREMELY STRONG financial security characteristics. ‘AAA’ is the highest Insurer Financial Strength Rating assigned by CRAB. AA1, AA2, AA3* (Double A): Have VERY STRONG financial security characteristics, differing only Slightly from those rated higher. A1, A2, A3 (Single A): Have STRONG financial security characteristics, but are somewhat more likely to be affected by adverse business conditions than Insurers with higher ratings. BBB1, BBB2, BBB3 (Triple B): Have GOOD financial security characteristics, but are more likely to be affected by adverse business conditions than higher rated insurers. BB1, BB2, BB3 (Double B): Have MARGINAL financial security characteristics. Positive attributes exist, but adverse business conditions could lead to insufficient ability to meet financial commitments.


B1, B2, B3 (Single B): Have WEAK financial security characteristics. Adverse business conditions are likely to impair their ability to meet financial commitments. CCC1, CCC2, CCC3 (Triple C): Have VERY WEAK financial security characteristics, and are dependent on favorable business conditions to meet financial commitments.. CC (Double C): Have EXTREMELY WEAK financial security characteristics and are likely not to meet some of their financial commitments. C (Single C): Currently highly vulnerable to non-payment, having obligations with payment arrearages allowed by the terms of the documents, or have obligations subject of a bankruptcy petition or similar action though have not experienced a payment default. C is typically in default, with little prospect for meeting its financial commitments. D (Default): 'D' is assigned to insurance companies which are in DEFAULT. The 'D' rating also will be used upon the filing of a bankruptcy petition or the taking of a similar action if payments on an obligation are jeopardized. *Note: CRAB appends numerical modifiers 1, 2, and 3 to each generic rating classification from AA through CCC. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category. RATING DEFINITION: Life Insurance Companies ST-1 : Highest Grade. Highest capacity for timely payment of short term policy obligations. ST-2 : High Grade. Strong capacity for timely payment of short term policy obligations. ST-3 : Average Grade. Average capacity for timely payment of short term policy obligations. ST-4: Below Average Grade. Below average capacity for timely payment of short term policy obligations. ST-5 : Inadequate Grade. Inadequate capacity for timely payment of short term policy obligations. ST-6: Lowest Grade. High risk of default or are currently in default. Part 2.32- The credit rating process for Life Insurance: CRAB’s analysis incorporates an evaluation of financial strength of the life insurer to meet all of its obligations. A logical starting point is to consider the various interests of the three stakeholders, namely, the policyholders, the shareholders and the regulators. To safeguard the interests of all the stakeholders, a life insurer must manage the collective risks passed on to it by its policyholders. The risks associated with the management of a life insurer arise from three main sources: insurance risk, investment risk, and business risk. Consequently CRAB’s rating methodology includes primarily an assessment of how prudently a life insurer manages its risks to meet all of its obligations. Our methodology makes an in-depth analysis of various risks undertaken by the life insurer. Our experienced analysts make detailed analysis of both quantitative and qualitative factors based on indepth discussions with the key management personnel of the life insurer. CRAB’s methodology incorporates a review of the life insurance industry as well as the macroeconomic trends affecting the industry in general. The nature of insurance regulation and the life insurer’s performance with regard to the compliance of the various provisions of the Insurance Act 1938, the Insurance Rules 1958 and the related circulars and guidelines issued by the Department of Insurance are also examined. The competitive position of the life insurer in relation to other life


Insurers within the industry are evaluated. CRAB then applies “CARAMELS” framework to assess the financial strength of the life insurer. Both the quantitative and qualitative factors are considered together before assigning a rating. C : Capital Adequacy A : Asset Quality R : Risks Underwritten A : Actuarial Liability

M : Management E : Earnings L : Liquidity S : Solvency Margin

CAPITAL ADEQUACY Capital adequacy in the context of Bangladesh is judged as to whether a life insurer has complied with the requirement of paid-up capital as per Section 6 of the Insurance Act 1938. The minimum paid-up capital as specified by the Regulatory Authority under the Insurance Act 1938 is not a good indicator on the level and Quality of a life insurer’s capital position. It is reported that the Regulatory Authority in Bangladesh starting from imposition of solvency margin requirement would gradually move towards risk based capital requirement. CRAB evaluates risk based capital requirement although no rule, regulation or guideline has yet been issued by the Regulatory Authority with regard to the methodology to be adopted by the insurers for calculation of risk based capital requirement. However, the Regulatory Authority must be concerned that the insurers honor its obligations to the policyholders while not putting at risk the solvency of the insurers. The risk based capital is a good measure of the insurer’s solvency assessment. CRAB evaluates the level of capital in relation to profitability and the insurer’s exposures to different kinds of risks. In the absence of any regulation relating to calculation of risk based capital requirement, CRAB has developed a formula for calculation of risk based capital for the particular insurer based on the particular risk characters the insurer has. Subject to the availability of data, the different sources of risk, namely asset default risk, insurance risk, asset-liability mismatching risk and business risk are explicitly taken into account. However, rating is based on the current regulatory requirement of capital adequacy. CRAB provides additional information on the requirement of risk based capital but it does not affect the current rating process. Rate of return is an important indicator of the insurer’s financial performance. Quality of assets has to be of excellent standing to ensure high rate of return on investment. Rate of return on each class of asset and the risks associated with each class and liquidity are evaluated by CRAB. Understanding the structure and composition of asset portfolio is very critical for analysis of asset quality. CRAB considers the following factors while analyzing the asset quality.  Investment strategy  Diversification  Credit risk

 Market risk  Liquidity  provisioning against loss on investment

Investment risk is determined by the risk that liabilities cannot be met. It is, therefore, important that investments are appropriate to the nature of liabilities. It is desirable to reduce risk of investment by diversification, which helps reduce the risk of major default and reduce volatility of asset value. Section 27 of the Insurance Act 1938 and the Rule made there under prescribes investment rule to be followed by insurers for investment of its funds. CRAB examines whether the insurer while making investment has complied with statutory obligation. CRAB makes assessment of overall diversification of investment portfolio by asset class and industry sector to identify any concentration of risk. Credit risk is evaluated by examining the insurer’s exposure to high-risk investment relative to the total investment portfolio and capital base. CRAB also evaluates market risk to identify potential changes in asset valuation due to change in market conditions. CRAB examines the marketability of investment and cash assets to meet the potential management expense, claims on the death of the policyholders, claims on surrenders and at maturities of the policies. Method of valuation of assets as at the balance sheet date is also examined. CRAB also examines the insurer’s policy of provisioning against loss on investment including default on loans to policyholders.


RISKS UNDERWRITTEN CRAB examines the nature of risks underwritten by the life insurer. CRAB considers the following factors while analyzing the nature of risks  Pricing of insurance products  Underwriting standard

 Reinsurance arrangements  Business risk

Pricing of insurance products is done by the actuary of the life insurer, which is based on, among others, assumptions of the expected mortality. Every insurer in Bangladesh is required to determine premium rates using the mortality table to be prepared by the Chief Controller of Insurance as stipulated in Section 3BB of the Insurance Act 1938. However, no such mortality has yet been prepared. In the absence of mortality table representing the mortality of assured lives in Bangladesh, the actuaries in Bangladesh have been using mortality tables prepared by other countries. There is a risk that the actual death claims may be significantly different from the expected death claims. CRAB, subject to availability of relevant data and information, evaluates whether there is any significant difference between the assumed mortality rates used in the determination of premium rates and the actual mortality experienced by assured lives of the life insurer. The main objective of underwriting is to charge a premium rate to each individual at the rate, which is broadly commensurate with the risk associated with each case. There may be a number of applicants who may be currently uninsurable because of uncertainty regarding the level of risk involved. A small number of impaired lives may be insured at rates higher than the standard rates. Moral hazard is eliminated through the process of underwriting. CRAB evaluates the process of underwriting of the life insurer. CRAB looks at the educational background and experience of key persons who are involved in the process of underwriting. Reinsurance is one of the key elements for a life insurer for reducing the risk caused by concentration of sum assured under individual policyholders. Reinsurance allows each life insurer to keep the benefits insured at any one time for any individual policyholder below a certain maximum level and thereby help reduce the probability of insolvency of a life insurer. CRAB examines the reinsurance policy of the life insurer, which determines both the method and terms under which reinsurance is arranged, credit worthiness of the reinsurer and the administration of reinsurance of the lives insured relating, in particular, to timely payment of reinsurance premiums, determination of reinsurance sums assured and settlement of outstanding reinsurance receivables. Business risk is usually considered as the contribution to a life insurer’s risk caused by its business activities. These primarily arise from the following elements: expense risk, discontinuance risk and distribution risk. A life insurer incurs expenses of management for its business operations. Rule 39 of the Insurance Rule 1958 has prescribed maximum allowable expenses of management for business operations of a life insurer. Expense risk is essentially the risk that the total expenses incurred by a life insurer are more than the allowable expenses as per the Insurance Rule. CRAB examines actual management expenses in relation to the maximum allowable management expenses to evaluate the long term sustainability of its business operations. Section 40A of the Insurance Act 193 provides for limitation of expenditure on commission. CRAB also evaluates whether the commission rates payable by the life insurer for procuration of insurance business are consistent with the commission rates allowed under the Insurance Act 1938.Voluntary discontinuance is a very important aspect of life insurance funds. There are essentially three modes of discontinuance: lapse surrenders and policies becoming paid-up. Sub-section 1 of Section 113 of the Insurance Act 1938 provides that a policy shall acquire surrender value if at least two consecutive years premiums have been paid. Therefore if a policyholder discontinues payment of premiums before payment of two consecutive years premium the policy does not acquire surrender value, and hence the policy becomes lapsed. First year’s expense of a policy are usually very high, often more than the first year’s premium, and, therefore with the lapsation of a policy the insurer incurs loss. Moreover high lapse ratio discourages the prospective policyholders to buy life insurance policies, which affect adversely the growth of life insurance business and could lead to ultimate insolvency. CRAB examines the actual lapse ratio of the


insurer as well as the firstyear expenses incurred by the insurer for selling a policy and evaluates the impact of lapse ratio on the insurer’s financial position. As per sub-section 1A of Section 113 of the Insurance Act 1938, every insurer is required to submit to Chief Controller of Insurance for his approval a statement showing the bases and formulae on which guaranteed surrender values of the policies issued by such insurer are determined. CRAB examines whether the insurer has complied with the requirement of the Act. Surrender values may easily exceed asset shares on the surrender of certain long-term contracts at early policy durations, as with high initial costs relative to the low annual premiums may be very small relative to early years of policy durations. There are other implications of minimum surrender values. CRAB makes an in-depth analysis of the insurer’s policy of guaranteeing minimum surrender values of policies issued under different plans and terms. CRAB also examines the ratio of paid-up policies to the total number of valued policies to evaluate the life insurer’s efforts to keep the policies in-force. Distribution risk is the risk of distributing too much surplus to the shareholders and/or to the policyholders and becoming insolvent as a result. Surplus distribution is made by the payment of bonuses to the with-profit policyholders and by the payment of dividends to the shareholders. One of the main responsibilities of the life insurer’s actuary is to recommend distribution of surplus within the framework of the relevant provision of the Insurance Act keeping in view the long-term solvency and profitability of the life insurer. CRAB reviews the life insurer’s distribution policy in relation to that of life insurance industry. Section 13 of the Insurance Act 1938 stipulates that every insurer shall cause an investigation to be made by an actuary into the financial condition of the life insurer. CRAB reviews valuation results. CRAB does not carry out actuarial valuation of liabilities; rather it uses the results of the valuation made by the life insurer’s actuary. Actuary’s management report, if available, is also used to evaluate the insurer’s current financial position and likely scenarios that may emerge under different set of assumptions. Management quality is a very important factor, which can make substantial difference to the life insurer’s performance. CRAB evaluates the performance of the management team by focusing on policy administration, actuarial management, data management and compliance of statutory obligations. Each of the factors can be subdivided as follows. Corporate Governance  Ownership pattern  Board of Directors  Regulatory compliance  Internal control  Management Information System Policy administration  Method of premium collection  Policy servicing  Claims settlement  Marketing Actuarial management  Product design  Reinsurance policy  Risk assessment  Expenses monitoring  Investment policy Statutory obligations  Actuarial reports and abstracts  Other statutory reports Data management  Quality of management information system


 Level and quality of computerization of accounting and valuation data  Level and quality of computerization of business operations Some of the above factors have been covered elsewhere. CRAB also looks at academic and professional qualifications in respective fields of key executives, management succession plan, business plan and performance in relation to stated objectives and plans. The actual investment yield as against the assumptions made in the pricing of products, actual management expense compared to expenses loaded in the premium formulae and actual mortality experience as against mortality rates assumed in the determination of premium rates have an important bearing on the profitability of a life insurer. The excess of life fund over the net liability (reserves) as valued by the actuary is the surplus generated as at the balance sheet date. The surplus after provision for taxes is distributed among the shareholders and policyholders on the recommendation of the actuary. CRAB examines the trend of surplus emerges during the intervaluation period. CRAB also looks at the proportion of the annual premium reserved as a provision for future expense and profits to the total of annual premiums. Gross and net yields are also examined. CRAB’s review includes calculation of numerous financial ratios and other qualitative measurements. The review is based on audited financial statements, statutory reports submitted to the Chief Controller of Insurance, insurer’s annual reports, actuarial reports and abstracts. In case detailed actuarial reports are not made available, valuation results in a summary form as prescribed by CRAB are used instead of detailed report on actuarial valuation. SOLVENCY MARGIN Solvency margin is a kind of risk-based capital assessment of a life insurer’s risk. Adequacy of solvency margin is the basic test to assess the long-term financial viability of a life insurer. Insurance companies are required either to comply with the statutory solvency margin requirement in addition to having minimum paid-up capital as per provision of the law or to comply with a more formal riskbased capital requirement. In Bangladesh, there is no statutory requirement for solvency margin nor has any requirement of risk-based capital for carrying on insurance business. CRAB has developed a formula for calculation of solvency margin, which is used to test the solvency of the life insurer. As soon as the Regulatory Authority of the insurance sector in Bangladesh requires insurers to comply with the solvency margin requirement CRAB shall adopt the formula as specified by the Regulatory Authority. LONGTERM – LIFE INSURANCE COMPANIES ENTITY RATING AAA (Triple A): Have EXTREMELY STRONG financial security characteristics. ‘AAA’ is the highest Insurer Financial Strength Rating assigned by CRAB. AA1, AA2, AA3* (Double A): Have VERY STRONG financial security characteristics, differing only slightly from those rated higher. A1, A2, A3 (Single A): Have STRONG financial security characteristics, but are somewhat more likely to be affected by adverse business conditions than Insurers with higher ratings. BBB1, BBB2, BBB3 (Triple B): Have GOOD financial security characteristics, but are more likely to be affected by adverse business conditions than higher rated insurers. BB1, BB2, BB3 (Double B): Have MARGINAL financial security characteristics. Positive attributes exist, but adverse business conditions could lead to insufficient ability to meet financial commitments. B1, B2, B3 (Single B): Have WEAK financial security characteristics. Adverse business conditions are likely to impair their ability to meet financial commitments.


CCC1, CCC2, CCC3 (Triple C): Have VERY WEAK financial security characteristics, and are dependent on favorable business conditions to meet financial commitments.. CC (Double C): Have EXTREMELY WEAK financial security characteristics and are likely not to meet some of their financial commitments. C (Single C): Currently highly vulnerable to non-payment, having obligations with payment arrearages allowed by the terms of the documents, or have obligations subject of a bankruptcy petition or similar action though have not experienced a payment default. C is typically in default, with little prospect for meeting its financial commitments. D (Default): 'D' is assigned to insurance companies which are in DEFAULT. The 'D' rating also will be used upon the filing of a bankruptcy petition or the taking of a similar action if payments on an obligation are jeopardized. *Note: CRAB appends numerical modifiers 1, 2, and 3 to each generic rating classification from AA through CCC. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category. Part 2.33- The credit rating process of Securitizations: The method of conversion of financial assets into tradable assets is known as securitization. Structured finance or securitized finance are a wide variety of debts, and related to securities whose promise to repay is backed by (a) the value of some financial assets or (b) the credit support from a third party to the transaction - securities supported wholly or mainly by pool of assets are generally referred to as either Mortgaged Backed Securities or Asset Backed Securities. In the transactions supported by assets, some or all of the cash flows from these assets are dedicated to the payment of principal and interest. There could be two types of cash flow structures, i.e. Pass-Through or PayThrough. Pass Through securities are equity instruments, in which assets are typically sold to a Trust and investor buy shares of the Trust. Pay- Through securities are debt obligations and raiser of funds pledges or sells the assets to a Special Purpose Vehicle (SPV). Common participants in the asset backed securities market: A. Sellers i. Banks ii. Financial Institutions iii. Pension Funds iv. Corporate Entities v. Mutual Funds B. Intermediaries i. Trust ii. Credit Rating Agency iii. Servicer (more often than not the Seller acts as the servicer) Asset Backed Securitization – Asset Types: Securitization essentially requires a steady and predictable cash flow stream and an underlying asset (which may be absent at that point of time in certain deals like future flows). Categorization is, therefore, possible based on the type of asset securitized.


A. Mortgage Backed: Mortgage backed securitization involves conversion of pools of mortgage backed housing loans into tradable debt securities. Such securities are termed Mortgage Backed Securities. The market for housing loans involving a housing finance company (HFC) and the borrower is referred to as the primary market. The market for securitized paper backed by such mortgage loans is the secondary market. B. Fixed Asset Receivables: Finance companies provide financing in the form of leases and hire purchase (typically 3 to 5 year assets). Pools of receivables from these assets may be securitized with the underlying asset providing the collateral security. C. Bills / Trade Receivables: Short term cash flows like trade receivables or external trade bills purchased by companies are also assets, which may be securitized. Typically, credit enhancement for such securities may be through Letters of Credit (LC), irrevocable guarantees or even over collateralization. One of the transaction structures may operate as follows: D. Non-Asset Backed Securitization – Future Flows: Unlike traditional Asset Backed transactions, future flow securitization utilizes the cash receivables of a corporate, based on its future performance. The sale here is of a particular stream of future cash receivables and no asset is sold or removed from the books of the entity. This form of structured offering has been particularly popular with the corporate entities while issuing international debt, whereby expected cash inflows ensure an instrument Rating superior to the sovereign Rating by mitigating some of the currency related risks involved. International future flow securitizations are structured debt offering of the corporate secured by receivables due from international obligors. The originating company that issues certificates or notes generally sells the future receivables to an offshore Trust. In addition, receivable obligors are directed to make payments directly to the offshore Trust. Advantages of Securitizations: The main advantages of securitization for entities holding financial assets are listed below: (a) Increased liquidity as relatively illiquid assets are converted into tradable securities; (b) Risk diversification; (c) Better asset liability management because securities offer an efficient way of tenure for matching of assets and liabilities; (d) Funding sources – securitization allows the issuers to find alternate sources of funding and also raise funds at low costs with improved Credit Rating. Rating Framework: Credit Ratings play a very important role in the issuance of structured debt instruments. The process of structuring of the instruments is generally quite complex which makes the task of assessing the credit risk extremely difficult for lay investors. Credit Ratings provide a simple and objective assessment of default risk in the form of symbolic indicators, which are easy to comprehend. The framework used for assessing the risk of default involves assessment of three types of risk i.e. credit risk, structural risk, and legal risk.


(a) Credit Risk: It is the risk of default by the borrowers. It refers to the uncertainty regarding the extent to which the borrowers of underlying assets backing the security will pay as per the terms of contract. (b) Structural Risk: It refers to the manner in which the transaction is structured to direct the payment stream (along with the collateral or support provider) to the investors. (c) Legal risk: It refers to the risk of potential insolvency of the issuer or other parties involved in the transaction. The methodology for Rating Asset Backed Securities would cover: 1. The originator: It’s current Credit Rating, underwriting standards, appraisal, monitoring and collection systems, financial performance, competitive position and strategy, experience and competence of management. 2. Asset quality: Loan to value ratio, EMI cover, historical repayment, delinquency and loss statistics, history of repossessions, ageing analysis of overdue, prepayments, losses on foreclosure, resale price and value of the underlying asset, availability of a resale market, presence or absence of recourse to originator and maturity profile of contracts. 3. Portfolio characteristic: Including pool size, customer or geographic concentrations, average seasoning; nature of asset composition of new or old assets (in vehicles and lease assets), loan size of contracts; difference with total pool characteristics (left-over pool may not be securitized) when selecting from large portfolio; the receivables should be chosen randomly selecting receivables that represent new property (i.e. Assets that have not been previously owned), are at least six months seasoned, have no current delinquencies, and are geographically dispersed. 4. Credit enhancement structure: The level of credit enhancement is usually based upon the selection of a prime pool that would have the lowest risk profile. Credit enhancement required for the prime pool to achieve a particular Rating is first determined. Other pools may achieve similar Ratings based on differing levels of credit enhancement. 5. Structure: Refers to allocation of cash flows to investors, recourse provision, combining of cash flows and reinvestment in certain structures. 6. Service provider, Trustee / Administrator / Receiving and Paying Agent: The ability, willingness, reputation and market standing of the third parties involved, power and authority bestowed on them and provision for appointment of successor. 7. Legal issues: include true sale characteristics of the transactions and building a bankruptcy remote structure – bankruptcy of originator should not hinder timely payment on the instrument and legal enforceability of the structure as a whole. Some of the criteria considered for determining bankruptcy remoteness are: Collections of the receivables securitized; Assets should not be co-mingled with the funds of the seller as far as possible; There should be no recourse against the seller for defaulted receivables beyond a reasonable anticipated default rate based on historical analysis; The transfer of the receivables should be accounted for as a sale on the seller’s financial statements.


CRAB RATING SCALES AND DEFINITIONS LONGTERM – DEBT INSTRUMENTS AAA (Triple A) Debt instruments rated AAA have extremely strong capacity to meet financial commitments. These are judged to be of the highest quality, with minimal credit risk. AA1, AA2, AA3 (Double A)* Debt instruments rated AA have very strong capacity to meet financial commitments. These are judged to be of very high quality, subject to very low credit risk. A1, A2, A3 (Single A) Debt instruments rated A have strong capacity to meet financial commitments, but susceptible to the adverse effects of changes in circumstances and economic conditions. These are judged to be of high quality, subject to low credit risk. BBB1, BBB2, BBB3 (Triple B) Debt instruments rated BBB have adequate capacity to meet financial commitments but more susceptible to adverse economic conditions or changing circumstances. They are subject to moderate credit risk. Such rated projects possess certain speculative characteristics. BB1, BB2, BB3 (Double B) Debt instruments rated BB have inadequate capacity to meet financial commitments. They have major ongoing uncertainties and exposure to adverse business, financial, or economic conditions. Such projects have speculative elements, and are subject to substantial credit risk. B1, B2, B3 (Single B) Debt instruments rated B have weak capacity to meet financial commitments. They have speculative elements and are subject to high credit risk. CCC1, CCC2, CCC3 (Triple C) Debt instruments rated CCC have very weak capacity to meet financial obligations. They have very weak standing and are subject to very high credit risk. CC (Double C) Debt instruments rated CC have extremely weak capacity to meet financial obligations. They are highly speculative and are likely in, or very near, default, with some prospect of recovery of principal and interest. C (Single C) Debt instruments rated C are highly vulnerable to non-payment, have payment arrearages allowed by the terms of the documents, or subject of bankruptcy petition, but have not experienced a payment default. Payments may have been suspended in accordance with the instrument's terms. They are typically in default, with little prospect for recovery of principal or interest. D (Default) D rating will also be used upon the filing of a bankruptcy petition or similar action if payments on an obligation are jeopardized. *Note: CRAB appends numerical modifiers 1, 2, and 3 to each generic rating classification from AA through CCC. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category. Part 3.1 Recommendation Analysis all the dynamics of credit rating of banks, some shortcomings have been detected. To have full-fledged recommendations for the credit rating, I want to make my recommendation in two parts. One part is for Banks, another one for CRAB.


Part 3.2 Recommendation for Banks Following recommendations are made for the banks: • With a view to strengthening the capital base of banks and make them prepare for implementation of Basel II Accord, Bangladesh Bank under BRPD circular No.5, May 14,2007, decided all bank will required to maintain Capital to Risk Weighted Asset ratio 10% at the minimum with core capital not less than 5%. All banks should take necessary steps to fulfill this requirement. • It is the high time for the bank to review its capital adequacy position that may stand under BaselII. It should be needed the banks capital requirement of the bank will increase on implementation of Basel-II and the bank should take risk preparation to face the challenge as and when it is due. • In our country maximum bank have high risky NPL ratio. All-out effort of the Bank management which included timely identification of overdue assets, initiating incentive schemes, building up task forces for recovery along with write off and rescheduling of loan which is long overdue etc will reduced the NPL ratio. • Bangladesh Bank has already advised the bank to raise the capital and reserve from Tk 1000 million to Tk 2000 million by June 30, 2009. Bank having capital shortfall will have to meet 50% by June 30, 2008 and remaining 50% by the end of June 2009. Most of the banks already fulfill the requirement; those banks who do not meet the requirement yet should take immediate step for this. Part 3.3 Recommendation for Credit Rating agency •

Restrictions on rating:

Not all the entities or securities should be rated by credit rating agencies. To ensure independence and objectivity in rating process, some restrictions should be imposed on rating of securities or entities related to the CRA. •

Disclosure of rating and rationale by the entity:

Respective circulars for banks and insurances guide the entities to publish the rating in any two national daily within one month of completion of the rating. But no guideline was prescribed thereby. Exploiting this opportunity, the entities are publishing their respective rating and only the strengths of its analysis, keeping weaknesses and lacking out of investors’ sight. •

Regulatory Framework for CRA:

It is about 12 years to promulgate the Credit Rating Companies Rules 1996 and about 6 years to the issuance of BRPD Circulars. But it is a matter of great regret that Bangladesh Bank is yet to set up a different wing to monitor the rating status of scheduled banks. To strengthen the regulatory framework of our money market it is proposed here that Bangladesh Bank should set up a monitoring cell for the rated banking companies to supervise, review and to advice on the rating results of each bank. •

Range of Rating Grade:

The Credit Rating Companies Rules 1996 instructs the companies to be rated before floating shares to the market through IPO or right issue but didn’t mention any range of rating to qualify itself for issuance. In 2002, Oriental Bank was rated “D” and floated shares through right issue. Eventually, the bank defaulted in 2007. Securities and Exchange Commission should specify a rating range for the entity to be qualified for issuance so that any such “D” rated entity could not issue public shares. It is


proposed here that the rating range primarily could be from “AAA” to “B-” for floating of shares and the rule could be stiffed with the advancement of our capital market Part 3.4 BIBLIOGRAPHIES: Financial Sector Assessment. (A hand book, published by the World Bank and international monetary fund) CRAB’s corporate brochures. Basel II (New capital adequacy framework) Part 3.5 References: • • • • •

• • • • • •

www.crab.com.bd Retrieve on July 03, 2011. www.crabrating.com Retrieve on July 15, 2011 www.standard&poors.com Retrieve on August 02, 2011 www.acraa.com retrieve on August 15, 2011 www.icra.como July 15, 2011 www.moodys.com July 15, 2011 Different rating report Annual report of banks Circulation of SEC Circulation of Bangladesh Bank mainly Basel II CRAB’s client lists www.bb.org.bd July 17, 2011

Study on credit rating process  

C redit Rating Agency of Bangladesh Ltd. (CRAB) was established in 2003 at the initiative of some leading personalities in private sector an...

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