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Evaluation of banks' condition: Credit rating versus camel rating
M Shamsul Arefin

          In response to some criticisms of credit rating agencies (CRAs) made by a writer in this newspaper, this would be worthwhile to note that such comments may foil the initiative of the Bangladesh Bank (BB) to formulate some fundamental guidelines in the recent times. Like making core risks management guidelines, making credit rating (CR) mandatory for banks is another imperative step on the part of the BB as the real regulator of the financial institutions (FIs) of the country. The initiative must be welcomed by all concerned without raising any issue against it or on its real outcome. We should let the policy be in place first.
We must also appreciate all those people who are providing critic's opinions on the requirement/success of such mandatory credit rating system (CRS) for banks, which will surely be helpful for the authorities concerned while preparing guidelines/modus operandi/evaluation criterion in this regard. This write-up is not aiming at criticising anyone but to present essentials of making the CR mandatory that will certainly pave the way for our adopting the Basel 11 by 2009. Considering the present backdrop of the financial sector, particularly, creeping of liquidity crisis severely with irregular intervals and taking over the management of the Oriental Bank by the BB, the latest directive of the monetary watchdog to banks to do their CR by a credit rating agency (CRA) on a half yearly basis and disclose the same to their clients is undoubtedly a timely decision.
Some pointed out with a note of criticism of the significance of the award of "rating" by the existing only two CRAs of Bangladesh (probably on the ground that there is no ample scope for bargaining on the price for rating or there is no adequate scope for challenging their rating). This writer considers that we must appreciate CRISL, the first CRA of the country for its importing this new phenomenon in Bangladesh. Later on, CRAB has started its operation in the same field. If the CR is made mandatory, some other CRAs will surely come into being. However, the number of CRA should be limited and licence should be conferred strictly on fulfilment of certain standards/criteria, particularly, of professional qualification, integrity, creditability, reputation of the people who own/head such institution. Limit of number, considering the size of our economy and the CR area, will ensure the quality of work, unlike our private universities or chartered accountancy (CA) firms, some of whom are often alleged for not ensuring the quality.
However, the quality of the work of CRAs can be judged by the people with the requisite knowledge. So, what is needed is the knowledge of users to figure out the significance of their work, thereby judge the quality. In our opinion, the quality of their work should not be criticised at this infant stage. They should be allowed couple of years to work on with some trials and errors. Again, scope remains open at this stage for some other firms which consider themselves more qualified to penetrate the market.
Argument was given in favour of fruitlessness of this benign venture, questioning the adequacy of "disclosures and transparency" in the financial reporting in Bangladesh. This matter deserves a serious attention since the issue poses a threat to one of the fundamental principles of accounting. In this regard, we think, the CA firm which will be engaged in auditing and certifying the concerned bank's financial affairs will also do its CR of that bank. On the other hand, the CRA which will be engaged in measuring the relative risk of default or capability of timely meeting different financial obligations will also provide their report on the concerned bank's financial affairs. Under such duel auditing and CR arrangement, their work can be verified and judged by each other.
Again, the BB auditors may carry out their audit on the issues and findings of earlier two institutions' reports. One may consider this process an overlapping and stringent one. But we should remember that banks are doing business with the money of innocent general public who keep their hard-earned money with banks for safety and good return. General public never expect that their money kept in the safe custody with banks would remain, in some cases, in a threat due to increasing volume of bad loans or, sometimes, recklessness of their bankers, and the vault of their cash, sometimes, needs to be taken care of by the BB administrator at a vulnerable stage. Banks' affairs need to be sincerely and intensively audited/examined by CA firms/external auditors, CRAs and BB auditors several times in a year and all of them must provide details of their findings so that subsequent corrective measures of irregularities, if any, can further be checked and full disclosure of affairs can be ensured. In this regard, another recent initiative of the Ministry of Finance in establishing "Financial Reporting Council (FRC)" which will have the authority to oversee the work of audit firms, examine financial statements of any organisations having public interest and take action against irregularities, if any, will surely be helpful for eliminating accounting juggleries/window-dressing and intentional incomplete disclosure. According to the draft of the framework of FRC, its Board of Directors will include representatives from the Institute of Chartered Accountants, the BB and the Securities and Exchange Commission (SEC).
Questions were raised in criticism of the BB's initiative about the modus operandi and necessity of the CRS, professional knowledge, social acceptability and efficiency of the persons engaged in carrying out the CR. So far we know, the CR in our country is being performed under a standard evaluation system as developed by other international CRAs of the world. The technique of rating on different specific parameters also supports different rules and regulations of the BB, companies/Bank Companies Acts and Basel Accord. This writer got a chance to know about one CRA that rated his institution. That CRA has got both equity and technical supports of two CRAs of Malaysia and Pakistan. A commercial bank of Pakistan and one of our specialised FIs have equity stake in that. That CRA is a member of the "Association of Credit Rating Agencies in Asia (ACRAA)". Some renowned FCAs, FCMAs and a University professor of business faculty promoted that CRA as a public limited company (PLC). Apart, that CRA has the requisite qualified professionals in its team. The local analysts have attended a good number of training programmes from at home and abroad. We have heard that in rating any institution, they need to send all collected datum/papers to their partners in Malaysia and Pakistan. The same organisation's CR is carried out by all the three partners and the consensus on the CR is reached through teleconferencing. So, they follow three-layer rating structure i.e., 1) analysts, 2) internal rating committee and 3) rating evaluation committee comprising senior professionals of all three partners. We hope that the second one has also got the same quality; otherwise the authority concerned would not confer the license. So, the questions of professional knowledge and social acceptability, We think, don't arise. However, the efficiency in quality rating is a time-bound matter that will definitely come after intensive experience gathered by our CRAs.
The modus operandi needs to be made clear. "Credit rating" is basically interpretation (explanation of the follow-on affect) of the analysis of some datum of selected areas. "Analysis and Interpretation" by the CRAs is the tertiary task. We can consider the case of a bank where the primary task of recording all financial activities/transactions in the form of various financial statements lies with the officials of accounts department; the secondary task of mainly ensuring the accuracy of the record in line with accounting principles lies with the appointed CA firm/external auditors. External auditors, mostly on a random selection basis (it is not possible for them to go through affairs of all branches of a bank rather they go through all/specific affairs of some selected branches), verify datum (financial activities/transactions recorded in financial statements by the accounts officials) from source documents (relevant vouchers etc.) and also provide some information (viz. different ratios) regarding the financial health of that bank up to the balance sheet date i.e. information are derived through financial analysis of past financial activities/transactions/historical accounting figures. So the information provided by external auditors are of the past. The present or the future position is not interpreted by them. The tertiary task, lain with the CRA, is providing information regarding credit worthiness of that bank of both present (short term's financial/liquidity management position up to next six month) and near future (long term's shock absorption capacity/safety position upto next one year).
Their interpretation is based on the analysis of financial statements (of both past and current fiscals since they will work on a half yearly basis) and consideration of some other factors that affect the performance/ condition of a bank viz. management experience, organisational and share holding structure, market conditions, business position, age of the bank, strength and weakness in core operational areas, business policy, status of compliance of various issues, system of operation, capital adequacy, liquidity position, investment/credit composition, loan-deposit ratio (LDO), quality of assets and any other strengths and weaknesses, thereby assess the overall risk of failure of that bank to meet financial obligations of both short and long terms. Since the task of the CRA is analysis and interpretation, the same can be done off-site as is the case of the BB for CAMEL rating.
However, whatever datum a CRA analyses, those are obtained from internal source of the organisation that undergoes rating through a set of questionnaires. As the BB Off-site Supervision Department gathers datum from financial statements, different statements forwarded to the BB and audit reports of other departments of the BB for CAMEL rating, CRAs also obtain other supporting papers/statements/source documents like financial statements, statements forwarded to the BB, policy guidelines, copy of some board resolutions as required, Memorandam and Articles of Association, daily affairs of branches as of balance sheet date etc., to tally the figures provided by the concerned organisation and shown in financial statements. For verification of some issues, they inspect directly on site. So, the modus operandi is acceptable.
Now, in answering the question of the necessity of the service of a CRA, despite the service of a CA firm as external auditors, we, without repeating the jobs of these two organisations, can say that the information regarding the health of an organisation provided by a CA firm does not help the investors or any other parties interested to know the present and the future (upto next one year) of the organisation. The CA firms' certified information are of the past (they may also show the past trend of couple of years) while the information provided by a CRA consist of the past, the present and the future (up to the next one year). Like CA firms, the BB CAMEL rating information is also of the past since capital adequacy, assets quality, earning and liquidity position are derived from financial statements of the fiscal year just concluded. Again, the CAMEL analysis/rating system, though based on specific parameters with specific benchmarks, does not, apparently, cover some more factors that affect the performance/condition of a bank.
The CRS covers some more areas, in addition to financial activities as recorded in financial statements. It appears that CAMEL needs, at least, to be CAMELS (S for System and Sensibility). A qualitative characteristic of accounting information is that it should be relevant to the time. In consideration of this characteristic of accounting information, auditors' report and the BB CAMEL rating information are not enough supportive for investors/ depositors as they can't invest/deposit their money based on the history without knowing the future.
Now, one can easily understand why the CR is so much important for a highly leveraged organisation like banks. Again, its importance is acutely felt in the present context of the financial market which is seriously volatile caused by frequent escalation of call money rate resulting from mainly mismatch of maturities of assets-liabilities of some FIs, for which those Fls are paying heavily in silence; continuous and dubious fall of composite price index of both the DSE and the CSE resulting in lack of confidence of investors for investment in shares of PLCs except a few, and gradual increase of interest rate of deposits, indicating huge demand for/crisis of deposits resulting from mainly going beyond the acceptable ceiling of LDO by some FIs. Moreover, some FIs are preparing for raising funds through issuance of long term bond or securitisation. Shouldn't credit rating be an imperative panacea for measuring how much these FIs are gearing up or what is their position/risk of paying short and long terms' liabilities/debts?
Again, in order to adopt Basel 11 that will require banks to disclose their risk information to the investors and set standards for internal risk management process, they need to rate their all individual risk weighted assets more judiciously than they are doing now. If all entities (individual, proprietorship, partnership and companies of both private and public) seeking equity/debt capital or assuming liabilities from the financial market are rated, it will be suitable for not only investors/debt providers but also bankers who need to exercise risk grading of borrowers under unique parameters with specific benchmark.
But unhealthy competition compels bankers to finance that the borrower whose proposal has been declined by a particular bank considering poor risk grading score. If the CR is made mandatory, borrowers' risk grading will be unique for all; there will be no variation in risk grading of borrowers among banks i.e., a borrower graded as the "Special Mention Category" by a bank will not be graded as "Acceptable Category" by another bank. Bankers will get a great support like they are currently getting in respect of security valuation by surveyors.
Again, while selecting new borrowers, bankers don't get enough information regarding borrowers from any sources other than the borrowers themselves. The CIB report does not cover detailed information regarding business condition and others. Again, borrowers' previous/existing bankers do not provide detailed information because of secrecy provision by Secrecy Act. Had CRAs entrusted with the job of providing the credit report from their developed database, bankers could get some urgent report regarding their borrowers from CRAs as they are currently getting credit reports of foreign exporters/importers from Dun and Brad street, Mumbai or Dubai through e-mail much earlier than they get CIB reports from the BB.
Again, as CRAs measure the risk of default, they would be able to tell us what will be the fate of our garments industry after 2008 when China will be free from the restriction imposed by the USA or other industries/business in the era of complete globalisation. In short, a CRA can work as a data/information bank in our country as we don't have such type of facilities providers. In order to fight back in the increasing global competitive environment, we need to be equipped with "information" and "technology".
However, the work of CRAs should not be kept out of monitoring. Regulators both the BB (for CR of Fls) and the SEC (for CR of all PLCs including Fls) need to check their all reports and evaluate the same. They need to see whether the evaluation system what they claim as of international standard considers unique parameters with unique benchmarks as is the case with the CAMEL rating. If unique benchmark for parameters does not exist, the rating will be more subjective rather than quantitative (to some extent, subjective judgement is required). The authorities concerned also need to review/audit their system/report and other issues from time to time to strengthen Credit Rating Act 1996 so that no case like Enron happens in Bangladesh.
In conclusion, it is to be reiterated that the CRAs should be allowed to work under the guidelines and monitoring of the concerned authority. The rating systems of the BB and CRAs regarding the condition of a bank need to be harmonised i.e., their rating signs ("A" or "AAA") should be unique to avoid any ambiguity among public. What is meant by CAMEL rating should also be meant by the rating of CRAs focusing on the past, the present and the future. Like share price index, the rating position of all FIs should be published in important dailies showing the previous and the current position on a quarterly basis and the significance of the position i.e., whether the condition is improving or deteriorating needs to be mentioned.
The writer is currently working with Shahjalal Islami Bank Limited as its Vice President


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