Ratings

The environment in which a bank operates is key to understanding the individual institution's operations. Experience shows that even the best bank in a country may undergo severe stress if the country in which it operates suffers a painful economic slowdown or recession, and the banking system's health declines substantially. This is true in mature as well as less developed markets.

With regard to economic risk, Standard & Poor's considers the risk level of a country's economy as it affects financial institutions, as opposed to the country's own credit quality. Included are the economy's strength, diversity, and volatility; the financial health of the corporate and individual sectors; and the government's ability to manage the economy through boom and recessionary periods.

The industry risk category contains many elements, and for any system there will be both positive and negative factors. While it is difficult to say which factors will outweigh others in any one system, generally Standard & Poor's gauges the dynamics of the financial service industry and to what extent those dynamics lead to more or less risk from the debtholder's or counterparty's point of view. In making this assessment, the quality of the regulatory regime and any governmental support mechanisms for banks can be especially important.

Banks are increasingly members of complex groups that play significant roles in their domestic economy or in the international markets. If a bank is a member of a larger group, Standard & Poor's will analyze the parent's operations to determine whether it adds to or detracts from the financial strength of the subsidiary bank. In many instances, being part of a larger group can have significant advantages in providing both domestic and international services. Standard & Poor's attempts to determine whether the group is willing or legally capable of supporting the bank, if necessary. At the same time, if the other group members are weaker than the bank, it must be determined to what extent income may be diverted to less profitable group members or loans may be made to group members or related parties on an uneconomic basis, to the detriment of the bank's financial condition.

In determining any rating, the past is important only as an indicator of the future. While many institutions furnish forecasts of expected levels of profitability and capitalization, face-to-face discussions with senior management are even more valuable. These discussions cover economic conditions, the current and expected regulatory and competitive environments, and future diversification and acquisitions. The review also includes a discussion of the extent to which profitability levels will be maintained and how required capital and liquidity levels will be financed. Management's philosophy in each of these areas is covered.

Standard & Poor's closely examines the accounting principles applied and the underlying assumptions utilized by a bank. The aim of this analysis is not to "score" the bank's accounting but to determine its impact on measures used in the more quantitative aspects of the rating analysis, such as asset quality, profitability, liquidity, and capitalization, as well as qualitative aspects such as management, including its financial policy and internal information systems.

Standard & Poor's analysis of accounting incorporates a study of the impact of national accounting principles and practices, which vary widely from country to country. Where appropriate, adjustments are made to financial statements to arrive at a more faithful representation of credit measures and improve comparability. Recent moves to adopt International Financial Reporting Standards (IFRS) in many countries, including those of the European Union, Australia, and Canada, as well as ongoing convergence of U.S. GAAP and IFRS, attempt to bring about greater comparability of banks' financial statements in various countries. Still, during the transition period, changing accounting standards will actually aggravate the complexity and difficulties in comparison. It is also unclear how many differences will remain in the practical application of IFRS in different countries, or how closely GAAP and IFRS will converge. Most importantly, differences will remain to the extent that certain accounting standards allow for optional accounting-treatment (e.g., elective mark-to-market, hedge accounting, or expensing of stock-based compensation) and also as they relate to the different assumptions used (such as those underlying loan loss provisions and charge-offs, degree of impairment of other assets, realization of deferred tax assets, valuation methodologies for derivative financial instruments, gains on sale of securitized assets, and valuation of retained-interests, etc.) by individual banks, which could lead to their accounting being more or less conservative from a credit perspective. Thus, despite recent moves toward convergence of accounting standards, Standard & Poor's envisions continuing analysis of individual banks' accounting and adjustment of their financial statements and ratios for analytical purposes as appropriate.

A discussion of credit risk encompasses the entire spectrum of an institution's activities, including loans, debt securities, equity investments, and on- and off-balance sheet counterparty exposures. The primary areas of concern are diversification and risk. Broadly speaking, Standard & Poor's analyzes the bank's total credit exposure through breakdowns by geography, collateral, maturity, industry sector, and type of borrowers (consumer, commercial, corporate, bank, or government). Rather than following a rigid framework, Standard & Poor's prefers to work with the bank's own internal information and reports in order to understand how the bank manages credit risk and the loan portfolio. Subjective factors such as the bank's experience and record in various types of lending and investment activities, competitive strengths, and market share are also important elements in the analysis. To compare institutions in different countries, Standard & Poor's makes extensive use of risk-adjusted asset quality indicators to reflect the relatively low-risk nature of certain government, interbank, and residential mortgage portfolios, and the high-risk profile of equity investments.

The process of credit approval, including lending criteria and approval limits, is carefully reviewed. Portfolio monitoring procedures and the auditing function are also discussed.

Concentration of risk is an important factor when reviewing the loan portfolio. Standard & Poor's determines if the bank offers general lending or if it specializes. When a significant portion of assets is employed in one particular segment of the economy, a request for additional information on that sector would be made, along with the rationale as to the bank's heavy involvement in the segment. To gauge the importance of individual borrowers, Standard & Poor's will review the bank's largest credit exposures. When analyzing foreign assets, country exposures are reviewed by amount, type, and maturity.

The history of nonperforming assets, loan losses, and provisions is of extreme importance. Data for each of the past five years are reviewed. In assessing the true level of problematic assets, Standard & Poor's looks beyond the regulatory definitions of problem loans to determine the level of assets on or off the bank's balance sheet for which the bank is exposed to a heightened level of credit risk.

When analyzing a bank's loan loss provisions Standard & Poor's begins by studying:

• The length of time an unpaid loan can continue before being declared delinquent;
• How long a provision is established for delinquent loans;
• How long the provision exists before the loan is charged off;
• If a provision indicates an impending write-off or if provisions made at a level comfortably above expected losses; and
• If charge-offs are made conservatively so that a large number are recovered fairly quickly, or if they are only recorded when ultimate loss is a virtual certainty.

Tax and regulatory considerations affect these decisions, and the responses to these questions will indicate which of the figures is the critical indicator of true loan losses.

Standard & Poor's examines in detail the level of market risk over the entire range of a financial institution's activities, whether on- or- off-balance sheet, for example, in its asset and liability structure, trading activities, securities underwriting business, etc. Management's strategy and general risk appetite in these areas are key.

The analysis of a bank's asset and liability mix includes an assessment of both external and internal factors affecting interest, maturity, and currency matching. The bank's general philosophy of asset and liability management and the systems for monitoring exposures is then discussed. Standard & Poor's is interested in management's record of reacting to changing circumstances. A bank that takes an interest rate or currency position and maintains the exposure regardless of subsequent events is viewed more negatively than one that quickly liquidates or closes open positions when markets move adversely.

With respect to trading risk management, Standard & Poor's due diligence process involves reviewing with management its policies, practices, and organizational structure in all areas of risk management, as well as an analysis of its results. In reviewing management policies and procedures, Standard & Poor's has found that most managements are aware of what proper policies should be and will purport to have such policies in place. The real issue is how well and consistently these policies are practiced. The assessment is performed through a comparative review of trading banks worldwide.

The analysis of liquidity focuses on both the nature and sources of a bank's funds, as well as on the character of its assets. Retail deposit-funded banks, with a large and diversified customer base offering a variety of deposit products through branch networks, contrast with wholesale banks, which access their funds from the capital markets. Both types of banks are examined as to the stability of their sources of funds, as well as the maturity structure of liabilities, and assessed as to their ability to meet obligations as they come due. The liquidity review also focuses on the ability to turn assets into cash, either through the natural maturation of the assets or through sale into liquid markets, another important dimension of a bank's being able to meet its obligations.

Credit is given for liquidity support mechanisms provided by the government, like access to funds from the central bank or deposit insurance programs, which tend to stabilize bank funding.

Any review of capital adequacy for a bank necessarily begins with governmental regulation, as countries have drafted their own interpretation of BIS capital guidelines or have other capital requirements. As these regulations may limit the flexibility or growth of the system, the establishment of minimum capital levels is frequently an important rating consideration. Standard & Poor's starting point, therefore, is a discussion with the appropriate regulators. In general, however, regulators aim to protect bank depositors, while Standard & Poor's is looking to timely repayment of principal and interest for debtholders and counterparties. Thus, while it is important that a bank meet the capital requirements of its domestic regulators, Standard & Poor's looks at a bank's capital structure in a broader context and does not include in its capital adequacy computations certain instruments that can only absorb losses in a reorganization or liquidation scenario.

After all of the necessary information is compiled, Standard & Poor's examines the bank's capital structure in both domestic and international contexts. Extensive use of risk-adjusted capital adequacy analysis, as well as the more traditional balance sheet measures are employed. With regard to international comparisons, adjustments are made in light of differing accounting and financial practices in order to make the entities' ratios as comparable as possible. However, the judgment of capital adequacy is also greatly influenced by the perception of relative profitability, risk profile, and asset quality.

In assessing profitability, key considerations are earnings levels, trends, and stability—that is, the long-term, core earnings power of a company. Standard & Poor's computes the ratio of earnings according to various definitions: operating, pretax, net income, etc., to average total assets, earning assets, and risk-adjusted assets. Additionally, net interest and net income margins are examined as are measures of efficiency. Reasons for performance in specific periods are analyzed and discussed, and a determination is made as to whether historical results are an accurate indicator of future performance. These same ratios are, with appropriate accounting adjustments, compared with those of banks of similar size and type in other countries.

Loan loss practices differ from country to country; thus, the loan loss provision may sometimes be considered a discretionary item, as opposed to an actual operating expense. Specific provisions are usually treated differently from general. Specific tax treatment may also have a major impact on "bottom-line" net income. In some countries, banks are beneficiaries of significant permanent tax benefits on lending in certain sectors. In others, there are opportunities for tax deferrals, such as through depreciation or loan loss provisions. Therefore, whether pretax or after-tax profits are emphasized will vary among countries.