global senior bond rating

8/11/2019 Global Senior Bond Rating

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TERM PAPER TOWARDS PARTIAL FULFILLMENT OF THE ASSESSMENT IN THE SUBJECT

OF MANAGEMENT OF FINANCIAL SERVICES

GLOBAL SENIOR BOND RATING

Submittedby:

Kastubh Madhavan

Roll No. 957

V Semester

B.B.A. LL.B. (Hons.)

Submitted to:

Dr. Rituparna Das

Assistant Dean

Faculty of Policy Science

National Law University, Jodhpur


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ACKNOWLEDGMENT

The author considers this paper as a major milestone in journey of his learning in the subject

of Management of Financial Services. Author would like to begin by Thanking God for the

wisdom and perseverance that he has bestowed upon him during this research project. Author

would also like to take this special opportunity to thank Dr. Rituparna Das for providing

such an opportunity to learn, in the form of this paper. Needless to say that without his timely

and valuable guidance and his patient replies to authorsqueries, howsoever trivial they may

have been, the author would not have been able to complete this paper. The experience has

definitely been an interesting and enriching one.

The author would also like to thank the library staff for their indispensable support and help

in the research work.


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TABLE OF CONTENTS

Acknowledgment ....................................................................................................................... 2

Senior Bonds: The Concept and Nuances .................................................................................. 6

Classification of Bond.......................................................................................................... 7

1) Bond Issuers .................................................................................................... 7

2) Priority ............................................................................................................... 8

3) Coupon Rate ...................................................................................................... 9

4) Redemption Features ......................................................................................... 9

Senior Bond ....................................................................................................................... 10

Issuing a Bond.................................................................................................................... 10

Changing Scenario and Need for Senior Bank Bond......................................................... 11

Trends in the Global Banking Sector ....................................................................................... 12

Global Banking Industry Overview ................................................................................... 13

Financial Performance of the Banking Industry ................................................................ 15

Banking Sector: Rating Outlook .............................................................................................. 17

Factors for a Rating Migration in the Banking Industry ................................................... 18

Asset Quality Pressures May Start Receding..................................................................... 19

Stress Tolerance Capability Still Adequate ....................................................................... 20

Capital Planning Critical .................................................................................................... 22

Funding Challenges Have Eased, May Recur .................................................................... 24

FY15 Performance: Another Challenging Fiscal ............................................................... 25

Problems in Banking Sector..................................................................................................... 25

The Problem of Asset Liability Mismatch ......................................................................... 25

What is it? ............................................................................................................ 26

The Way Out ........................................................................................................ 26

Over Dependence on Short-term Funding ......................................................................... 26

Already lengthening Loan Tenors ..................................................................................... 27


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Policy Challenges............................................................................................................... 27

Diluted Monetary Transmission ........................................................................................ 27

The Pre 2014 Scenario and Solutions ...................................................................................... 27

Limited Options Available to Banks.................................................................................. 27

RBI Guidelines................................................................................................................... 28

Senior Bonds Can Be the Answer ...................................................................................... 29

The Need for Senior Bank Bonds ............................................................................................ 29

Positive from Capital Market Development Perspective ................................................... 30

International Experiences................................................................................................... 30

Senior Bonds and Banking Scenario.................................................................................. 30

The Senior Bond Solution to Asset Liability Mismatch .................................................... 31

Improving Credit Profile of Banks .................................................................................... 32

Boosting the Liquidity Coverage Ratio ............................................................................. 32

The Impact on Interest Rate Sensitivity ............................................................................. 32

Rating Methodology ................................................................................................................ 32

Moodys Global Bank Rating Methodology...................................................................... 33

Determine the Bank Financial Strength Rating ................................................... 33

Translate the BFSR to a Baseline Credit Assessment ......................................... 34

Consider Support Factors ..................................................................................... 34

Understanding Moodys Ratings......................................................................... 34

ICRA: Credit Rating Methodology for Banks ................................................................... 35

Business Risk ....................................................................................................... 36

Financial Risk ...................................................................................................... 36

Operating Environment ........................................................................................ 36

Regulatory Environment ...................................................................................... 36

Ownership Structure and Government Support ................................................... 37

Governance Structure........................................................................................... 37


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Franchise .............................................................................................................. 37

Management, Systems and Strategy and Risk Management ............................... 37

Risk Management ................................................................................................ 38

Financial Performance ......................................................................................... 38

Asset Quality ........................................................................................................ 38

Diversity of Funding and Liquidity ..................................................................... 38

Earning Stability and Prospects ........................................................................... 40

Capital Adequacy ................................................................................................. 40

Conclusion ............................................................................................................................... 41

References ................................................................................................................................ 43


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SENIOR BONDS: THE CONCEPT AND NUANCES

Senior Bank Bonds are being projected as the game changer for banks. Senior bonds present

an opportunity for lower refinancing costs and long term investments. The bonds are perhaps

the banks solution to asset liability mismatcheswhich have become glaring of recently.

To understand the nature of senior bank bonds, an understanding has to be developed with

respect to bonds. Debt can take many forms: loans, commercial paper and bonds. Bonds are

one way a company can raise capital to grow its business. A bond is an agreement in which a

company agrees to either pay back the value of the bond with interest after a certain period of

time, or promises to make regular interest payments on the value of the bond

Bonds are bought and sold on the commodities markets and are a way for a company to get

private financing. They may offer a higher rate of interest for more secure terms than an

investor can get elsewhere, or cost the company less in interest than it would pay to a bank or

lender.

All bonds are a form of debt, but not all debts are bonds. Bonds are often only a part of how a

company or project obtains funding. Most commercial lenders will not fund 100 percent of a

project, which means that the company must either have cash on hand to contribute or must

raise additional funds. Bonds can be a source of those funds.

Bonds have certain tax benefits for both the issuer and the holder. It is not just companies that

use bonds for fundraising purposes; municipalities often use them to fund projects like

schools, hospitals and other public works, helping to keep local sales and property taxes

lower.

In more technical terms a bond can be described as a debt investment in which an investor

loans money to an entity (corporate or governmental) that borrows the funds for a defined

period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and

U.S. and foreign governments to finance a variety of projects and activities.

Bonds are commonly referred to as fixed-income securities and are one of the three main

asset classes, along with stocks and cash equivalents. The indebted entity (issuer) issues a

bond that states the interest rate (coupon) that will be paid and when the loaned funds (bond

principal) are to be returned (maturity date). Interest on bonds is usually paid every six

months (semi-annually). The main categories of bonds are corporate bonds, municipal bonds,


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and U.S. Treasury bonds, notes and bills, which are collectively referred to as simply

"Treasuries."

Two features of a bond - credit quality and duration - are the principal determinants of a

bond's interest rate. Bond maturities range from a 90-day Treasury bill to a 30-year

government bond. Corporate and municipals are typically in the three to 10-year range.

CLASSIFICATION OF BOND

When it comes down to it, a bond is simply a contract between a lender and a

borrower by which the borrower promises to repay a loan with interest.However,

bonds can take on many additional features and/oroptions that can complicate the

way in whichprices and yields are calculated. The classification of a bond depends on

its type of issuer, priority, coupon rate and redemption features. The following chart

outlines these categories of bond characteristics:

Figure 1: Bond Characteristics Source: investopedia.com

1) Bond Issuers

As the major determiner of a bond's credit quality, the issuer is one of the most

important characteristics of a bond. There are significant differences between bonds

issued by corporations and those issued by a state government/municipality or

national government. In general, securities issued by the federal government have

the lowest risk of default while corporate bonds are considered to be riskier

ventures. Of course there are always exceptions to the rule. In rare instances, a very

large and stable company could have a bond rating that is better than that of a

municipality. It is important for us to point out, however, that like corporate bonds,

government bonds carry various levels of risk; because all national governments aredifferent, so are thebond they issue.


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International bonds (government or corporate) are complicated by different

currencies. That is, these types ofbonds are issued within a market that is foreign to

the issuer's home market, but some international bonds are issued in the currency of

the foreignmarket and others are denominated in another currency. Here are some

types of internationalbonds:

Eurobond: The name is a misnomer. Although the euro is the currency used by

participating European Union countries, eurobonds refer neither to the European

currency nor to a Europeanbond market. A eurobond instead refers to any bond that

is denominated in a currency other than that of the country in which it is issued.

Bonds in the eurobond market are categorized according to the currency in which

they are denominated. As an example, eurobond denominated in Japanese yen but

issued in the U.S. would be classified as a euroyenbond.

Foreign bondsare denominated in the currency of the country in which a foreign

entity issues thebond. An example of such a bond is the samuraibond, which is a yen-

denominated bond issued in Japan by an American company. Other popular foreign

bonds include bulldog and yankee bonds.

Global bonds are structured so that they can be offered in both foreign andeurobond markets. Essentially, global bonds are similar to eurobonds but can be

offered within the country whose currency is used to denominate the bond. As an

example a global bond denominated in yen could be sold to Japan or any other

country throughout the Eurobond market.

2) Priority

In addition to the credit quality of the issuer, the priority of the bond is a determiner of the

probability that the issuer will pay you back your money. The priority indicates your place in

line should the company default on payments. If you hold an unsubordinated ( senior)

security and the company defaults, you will be first in line to receive payment from the

liquidation of assets. On the other hand, if you own a subordinated (junior) debt security, you

will get paid out only after the senior debt holders have received their share.


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3) Coupon Rate

Bond issuers may choose from a variety of types of coupons, or interest payments. Straight,

plain vanilla or fixed-rate bonds pay an absolute coupon rate over a specified period of time.

Upon maturity, the last coupon payment is made along with the par value of the bond.

Floating rate debt instruments or floaters pay a coupon rate that varies according to the

movement of the underlying benchmark. These types of coupons could, however, be set to be

a fixed percentage above, below, or equal to the benchmark itself. Floaters typically follow

benchmarks such as the three, six or nine-month T-bill rate or LIBOR.

Inverse floaters pay a variable coupon rate that changes in direction opposite to that of short-

term interest rates. An inverse floater subtracts the benchmark from a set coupon rate. For

example, an inverse floater that uses LIBOR as the underlying benchmark might pay a

coupon rate of a certain percentage; say 6%, minus LIBOR.

Zero coupon, or accrual bonds do not pay a coupon. Instead, these types of bonds are

issued at a deep discount and pay the full face value at maturity.

4) Redemption Features

Both investors and issuers are exposed to interest rate risk because they are locked into either

receiving or paying a set coupon rate over a specified period of time. For this reason, some

bonds offer additional benefits to investors or more flexibility for issuers:

Callable, or a redeemable bondfeatures gives a bond issuer the right, but not the obligation,

to redeem his issue of bonds before the bond's maturity. The issuer, however, must pay the

bond holders a premium. There are two subcategories of these types of bonds: American

callable bonds and European callable bonds. American callable bonds can be called by the

issuer any time after the call protection period while European callable bonds can be called

by the issuer only on pre- specified dates. The optimal time for issuers to call their bonds is

when the prevailing interest rate is lower than the coupon rate they are paying on the bonds.

After calling its bonds, the company could refinance its debt by reissuing bonds at a lower

coupon rate.

Convertible bondsgive bondholders the right but not the obligation to convert their bonds

into a predetermined number of shares at predetermined dates prior to the bond's maturity. Of

course, this only applies to corporate bonds.


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Puttable bondsgive bondholders the right but not the obligation to sell their bonds back to

the issuer at a predetermined price and date. These bonds generally protect investors from

interest rate risk. If prevailing bond prices are lower than the exercise par of the bond,

resulting from interest rates being higher than the bond's coupon rate, it is optimal for

investors to sell their bonds back to the issuer and reinvest their money at a higher interest

rate.

Unlimited Types of Bonds

All of the characteristics and features described above can be applied to a bond in practically

unlimited combinations. For example, you could theoretically have a Malaysian corporation

issue a subordinated yankee bond paying a floating coupon rate LIBOR + 1% that is callable

at the choice of the issuer on certain dates of the year.

SENIOR BOND

Thus, concluding from the above points a senior bond can be defined as a debt security that

has a prior or superior claim on the issuer's assets and income than the other (junior) bonds

issued by the same entity.

In other words, it is a bond that has higher priority compared to another in the event of

liquidation. That is, if a company goes bankrupt and is liquidated, holders of a senior bondmust be paid before holders of junior debt. It is a type of senior security.

ISSUING A BOND

Bonds are issued by public authorities, credit institutions, companies and supranational

institutions in the primary markets. The most common process for issuing bonds is through

underwriting. When a bond issue is underwritten, one or more securities firms or banks,

forming a syndicate, buy the entire issue of bonds from the issuer and re-sell them to

investors. The security firm takes the risk of being unable to sell on the issue to end investors.

Primary issuance is arranged by bookrunners who arrange the bond issue, have direct contact

with investors and act as advisers to the bond issuer in terms of timing and price of the bond

issue. The bookrunner is listed first among all underwriters participating in the issuance in the

tombstone ads commonly used to announce bonds to the public. The bookrunners'

willingness to underwrite must be discussed prior to any decision on the terms of the bond

issue as there may be limited demand for the bonds.


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In contrast, government bonds are usually issued in an auction. In some cases both members

of the public and banks may bid for bonds. In other cases only market makers may bid for

bonds. The overall rate of return on the bond depends on both the terms of the bond and the

price paid. The terms of the bond, such as the coupon, are fixed in advance and the price is

determined by the market.

In the case of an underwritten bond, the underwriters will charge a fee for underwriting. An

alternative process for bond issuance, which is commonly used for smaller issues and avoids

this cost, is the private placement bond. Bonds sold directly to buyers and may not be

tradeable in the bond market.

Historically an alternative practice of issuance was for the borrowing government authority to

issue bonds over a period of time, usually at a fixed price, with volumes sold on a particular

day dependent on market conditions. This was called a tap issue or bond tap

CHANGING SCENARIO AND NEED FOR SENIOR BANK BOND

Over the last few years the Indian financial markets have witnessed wide ranging changes at

fast pace. Intense competition for business involving both the assets and liabilities, together

with increasing volatility in the domestic interest rates as well as foreign exchange rates, has

brought pressure on the management of banks to maintain a good balance among spreads,profitability and long-term viability. These pressures call for structured and comprehensive

measures and not just ad hoc action. The Management of banks has to base their business

decisions on a dynamic and integrated risk management system and process, driven by

corporate strategy. Banks are exposed to several major risks in the course of their business -

credit risk, interest rate risk, foreign exchange risk, equity / commodity price risk, liquidity

risk and operational risks.

The present work tries to analyse the global senior bank bond rating. Senior bank bonds have

developed as a better alternative to raise money providing banks with a longer period

security. For the public, the senior bank bonds are a lower risk instrument. The long-term

bonds introduced in the Union Budget 2014-15 and notified by the Reserve Bank of India

(RBI) on 15 July 2014 is an effective source for Indian banks to fund infrastructure and

mortgage loans which formed 25% of the banking systems loans at end-FY14. For most

banks, these will be the first long-term, non-capital debt instrument to be issued in the

domestic market. Their importance lies in narrowing the asset-liability mismatches in thebanking system.


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In June 2013, India Ratings & Research (Ind-Ra) said that the mismatch was unsustainable in

many banks and diluted the transmission of monetary policy, while forcing the yield curve to

remain flat-to-inverted. The new bonds can help banks correct these weaknesses.

Borrowed money that a company must repay first if it goes out of business. Companies have

a number of options for obtaining financing, including bank loans and the issuance of bonds

and stocks. Each type of financing has a different priority level in being repaid if the

company decides to liquidate. If the company goes under, the holders of each type of

financing have different levels of rights to the company's assets.

If a company goes bankrupt, senior debtholders, who are often bondholders or banks that

have issued revolving credit lines, are most likely to be repaid, followed by junior debt

holders, preferred stock holders and common stock holders. Senior debt is secured by

collateral, and that collateral can be sold to repay the senior debt holders. As such, senior debt

is considered lower risk and carries a relatively low interest rate. Even though senior debt

holders are the first in line to be repaid, they will not necessarily receive the full amount they

are owed in a worst-case scenario.

TRENDS IN THE GLOBAL BANKING SECTOR

The banking industry experienced a strong recovery after the worst of the financial crisis, but

continued to be weighed down due to the ongoing Eurozone crisis and concerns of sluggish

growth in the United States. An evolving banking landscape in emerging economies

(especially China and Latin America) is expected to transform the banking industry in the

future. Meanwhile, regulations continue to evolve and create an ever-tightening regulatory

environment for the banking industry.

Assets of the Top 1000 banks globally grew by 4.9% in 2012 and registered a growth acrossall regions in 2012, except in Europe where asset growth was down 0.5% due to concerns

about Eurozone debt. The Latin America region registered an impressive growth of 20.5% in

assets in 2012, as compared to the other global regions. This resurgence of the economies in

the region was driven primarily by rising consumerism and financial inclusion.

Pre-tax profitability of the banking sector has witnessed a moderate growth of 4.6% during

201112. This growth has been largely driven by the emerging economies while the

profitability of European banks has continued to be negatively impacted due to the Eurozone


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crisis. For banks, top priorities include regulatory compliance, improving asset quality,

enhancing customer centricity, focusing on digital convergence, and tackling competition

from non-banks. Banks are therefore making business and technology investments to change

their business models to comply with new regulatory requirements, enhancing capital

adequacy, rolling out new channels such as social media, and leveraging customer data

analytics and predictive analytics to enhance customer understanding and prevent fraud.

GLOBAL BANKING INDUSTRY OVERVIEW

The financial crisis severely impacted the asset and profitability growth of the global banking

sector, which started to recover during 2009 and 2010. The growth rate of assets for the Top

1000 banks grew by 5.9% during 200911, reaching well above the pre-crisis level.

However, during 201112 the growth moderated to 4.9% due to the ongoing Eurozone crisis,

which was to some degree compensated by the growth of assets in the Asia-Pacific and Latin

American regions.

Profits-before-tax (PBT) of the banking sector also witnessed strong growth during 2009 and

2010. The PBT of the Top 1000 banks increased by $553 billion between 2008 and 2011, and

further increased by 4.6% in 2012, primarily due to the efforts taken by the banks to reign in

their costs and disposition of non-core assets and unprofitable assets. However, due to the

effects of the Eurozone crisis, European banks faced significant pressure regarding

profitability.

Figure 2: Profits-Before-Tax ($bn) and Income-to-Assets Ratio (%) of Top 1000 Global Banks (by Assets),

20082012


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The financial crisis underscored the sharp differences in the performance of the banking

sector across emerging and developed markets. Emerging markets such as Latin America and

Asia-Pacific remained resilient to the crisis in contrast to developed markets where the

banking sector experienced sharp losses. The income-to-assets ratio of top global banks

declined by 10 basis points in 2012. Although Europe had a huge 45% share of total assets,

its smaller share in total pre-tax profits (8%) was a result of significant losses and write-

downs from the ongoing Eurozone crisis. On the other hand, the Asia-Pacific region had a

37% share in total assets but 62% share in total pre-tax profits due to strong macro-economic

fundamentals. North American banks had a 16% share of total assets but a share of 24% in

total pre-tax profits, as most of them continue to improve their profitability after the subprime

crisis.

In 2012, banks were impacted by the strong economic headwinds, heightened regulatory

pressure, persistently high cost structures, and low customer trust. Market volatility and

Eurozone debt concerns continued to weigh down the underperforming European banking

sector index. After the financial crisis, the banking sector had come under heightened

regulatory scrutiny, which remains a key concern for the industry as regulatory reforms

continue to emerge. Imposition of higher risk management standards, curtailment of

proprietary trading activities, heightened scrutiny of business models, imposition of morestringent capital adequacy norms, and increased reporting requirements have adversely

impacted the profitability and growth prospects of the banking industry.

Figure 3: Bi-Yearly Closing Banking Indices, Dec 2006Jun 2013


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In todays context, risk management and the evolving regulatory landscape remain the key

focus for banks. Emerging priorities include reducing unproductive assets from non-

profitable segments and geographies, and focusing on core business areas to improve

efficiencies. Banks globally are under increased scrutiny due to recent cases of financial

fraud. Another challenge is the threat from non-banks (such as retail chains, non-banking

financial services companies) that are increasingly emerging as potential competitors to

traditional banks.

FINANCIAL PERFORMANCE OF THE BANKING INDUSTRY

Assets of the top banks grew across all regions in 2012, except in Europe where asset growth

was slightly down by 0.5%. The Latin America region registered an impressive growth of

20.5% in 2012, as compared to the other regions. This resurgence of the economies in the

region was driven primarily by rising consumerism and financial inclusion.

The banking industry assets in the emerging markets of the Latin America region and Asia-

Pacific grew the most in 2012, at 20.5% and 9.5%, respectively. The key reason for growth in

emerging markets such as China, India, and Brazil can be attributed to financial inclusion of

the bankable income segment. In contrast to this, while North America grew by 6.1%,

during the same period Europe declined marginally by 0.5%.

In terms of operational efficiency, the banking industry experienced very contrasting results.

Return on assets (ROA) for top banks in Europe and Latin America declined in 2012, but

improved marginally for banks in the Asia-Pacific and North America regions. Emerging

market banks led the way on ROA where it remained highest for Latin America at 1.6%,

followed by the Asia-Pacific region at 1.1%. The ROA for top global banks in the Latin

America region decreased significantly by 25 basis points in 2012, which can be primarily

attributed to the strong growth in the assets of the banks compared to profitability.

On the other hand, the ROA for European banks declined by nine basis points in 2011, due to

substantial losses and write-offs suffered from the impact of the Eurozone crisis. This led to a

decrease in the assets along with the profitability, as most banks had substantial exposure to

sovereign debt held by governments. The ROA of banks in North America witnessed a

marginal increase of four basis points, as the economy started recovering in 2012.

Cost-to-income ratios decreased for banks across all regions except for the European region,

where the ratio increased in 2012. The cost-to- income ratio for North American banks


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decreased by 0.4% points in 2012, to reach 67.8% compared to 68.2% in 2011. This decrease

was primarily driven by efforts taken by banks to reduce their costs along with the increase in

profitability. But the cost-to-income ratio for North American banks is highest compared to

other regions due to several ongoing and upcoming legislation, such as Debit Interchange

regulations (part of the Dodd-Frank Act) and Basel III, which are keeping operating costs

higher for banks. The cost-to-income ratio for European banks increased by 4.3% points in

2012, to reach 64.2% compared to 59.9% in 2011, reflecting the impact of the ongoing

regulations and substantial write-downs by major banks. In 2012, banks in emerging markets

observed a decrease in the cost-to-income ratio of 10% points and 5% points for Asia-Pacific

and Latin America, respectively. The decrease in these regions can be attributed to the

improving economic conditions leading to higher operating incomes.

Strengthening the capital positions of banks has been a key regulatory focus for authorities

after the financial crisis. In order to comply with the new Basel III requirements, top banks

across all regions are making efforts to improve their Tier 1 capital ratios. While European

banks have registered the highest improvement in the Tier 1 capital ratio in 2012, they are

still lagging behind other regions. Tier 2 capital ratios realized a marginal change in 2012,

except in Latin America, where this measure increased considerably, as the major Brazilian

banks had made significant issuance of Tier 2 capital before the Central bank enforcedissuance of Basel III compliant debt. With the new capital requirements proposed by the

Basel III norms (expected to be phased in by Jan 2015, post the transition period of 2013-15),

there is an expectation that banks will increase their Tier 1 capital ratio from the current 4%

to 6% by 2015, thus putting further pressure on the bottom line. In order to ensure that they

are in compliance with regulations, banks have started restructuring efforts to convert their

hybrid capital (a part of Tier 2 capital) to core capital and deleverage their balance sheets.

Figure 4: Capital Phase-In Requirements under Basel III


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Basel IIIs focus is on capital and funding, and specifies new capital target ratios for banks to

comply:

A common equity (or core equity) Tier 1 requirement of at least 4.5% of risk

weighted assets (RWA)

A Tier 1 capital of at least 6.0% of RWA

A Total Capital (Tier 1 + Tier 2) of at least 8% of RWA

In response to the Basel III regulations, banks are already building their capital and funding

stocks along with reducing risk off their books in several ways, such as disposition of non-

core assets. Due to the ongoing Eurozone crisis and difficulty in enhancing their capital,

European banks are lagging behind other regions in terms of enhancing their Tier 1 capital

ratios.

The banking sector continues to face key challenges that may have an impact on the financial

performance of the banking industry, such as:

Evolving customer demands and the need for developing new products and services to

cater to new customer segments

Increasing cost of operations due to heightened regulatory and compliance pressure

Changing customer channel preferences with increasing adoption of mobile and social

media

Rising competition from non-banks (such as retailers and telecom firms)

BANKING SECTOR: RATING OUTLOOK

Cyclical Easing: Stressed assets may reach 14% of loans by March 2015 (9% in March

2013). By then, improvement in industrial activity on the back of a gradual pick-up in the

investment cycle could slow NPL accretion and improve recoveries in most sectors. Any

sharp pullback in delinquencies is unlikely as corporate leverage today is significantly

higher than in 2008 and it may take a few years of elevated growth before leverage turns

comfortable.

Finely Poised: The easing in credit pressures is premised on a pick-up in growth.

However, the premise may have to be reversed if growth remains elusive and volatility in the

currency market forces a continuation of tight monetary conditions. High corporate leverageindicates a limited capacity to absorb further pressures on costs and banks could face a


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fresh wave of NPLs if corporate profitability continues to fall. Restructuring of infrastructure

loans will likely continue as the sector grapples with execution challenges and rising costs.

About 20% of infrastructure loans were restructured till end-March 2013 and the proportion

could increase to 30% - 40% over the next two years. Credit losses are however expected

to be contained as the long-term viability of most projects remains intact given the

nationwide shortages of power, roads and quality urban infrastructure.

Focus on Capitalisation: The demand for Tier 1 capital will remain modest in FY15 but will

increase sharply in subsequent years. The governments estimated equity injection of

USD23bn till FY18 will form the largest contribution and its commitment provides

considerable rating stability for government banks and comfort to senior creditors. The larger

private banks are expected to maintain their above-average capitalisation levels based on

better access to the equity capital markets.

Lower Profitability Levels: Profitability (ROA) of government banks will trend lower than

the historic level of 0.9% given the regulatory push to increase loan loss reserves to protect

against forex volatility and cyclical downturns. The through-the-cycle ROA of banks may

fall by 10-15bp to help boost total loan loss reserves (specific and general) to nearly 70% of

gross NPLs on a sustained basis from the current level of 63%, which will improve banks

cyclical resilience.

Funding Challenges: Many banks benefitted from the loan slowdown in FY14 and reduced

their funding gaps through lower dependence on bulk deposits. The structural imbalance may

recur if loan growth picks up. Banks are not permitted to raise long-term bonds, which limits

their ability to manage funding gaps and to fully transmit any easing in monetary policy.

FACTORS FOR A RATING MIGRATION IN THE BANKING INDUSTRY

Improved Funding, Concentration Levels: Improvements in funding gaps and single-name

concentrations together with increased capitalisation levels and higher loan loss provisions

may result in a positive outlook for banks whose ratings are driven by performance.

Pressures on capital ratios due to weak profitability, rapid loan growth and delays in equity

injections may lead to the sector outlook being revised to negative. Issuer ratings of

government banks will mostly remain resilient on expectations of continued

government support.


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ASSET QUALITY PRESSURES MAY START RECEDING

Ind-Ra expects NPL accretions to slow down from the second half of FY15, on the likelihood

of higher economic growth driving corporate performance. The rebound to 5.6% in real GDP

growth in FY15 will likely be driven by an investment revival coupled with stronger

performance from export-led sectors (see Economic Outlook: Industry and Services to Push

Growth in FY15). Stable or marginally lower interest rates are expected to prevail, which

should help improve corporate margins and interest coverage measures, which are currently

at a five year low.

However, leverage levels (debt / EBIDTA) in most credit intensive sectors continue to stay

elevated and in many cases more than double the levels witnessed in 2008. A sustained

reduction in corporate leverage is unlikely in the absence of a pick-up in cash flow generation

from current investments, which could require two to three years of consistently stronger

growth. Delinquency levels, therefore, are expected to recover only over the medium-term.

Figure 5: Large Corporate Leverage Snapshot - Key Industries

Steep currency depreciation in mid-2013 brought into focus the credit risks from unhedged

foreign currency exposures of borrowers. Further depreciation would impact both immediate

debt servicing capability and leverage levels of projects funded by forex debt. Ind-Rasstudy

on the vulnerability of leveraged corporates to currency depreciation indicates that stress is

likely to be concentrated in a few sectors. However, variance in earnings sensitivity among

companies within a sector is high.


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Figure 6: Impact of 18% Rupee Depreciation on Corporate EBID; Figure 7: Impact of RBI Guidelines: 18%

Depreciation

New regulatory guidelines require banks to make additional provisions for loans to borrowers

who may be significantly impacted by currency depreciation from FY15. Ind-Ra estimates

that banks credit costs may increase by 10bp-12bp, leading to a decline in the systems FY15

ROA by around 6bp-8bp. The impact is likely to be greater on banks which have greater

exposure to the affected sectors identified above.

Infrastructure loans, which form a large and growing proportion of the overall loan book,

remain a key risk to asset quality. Operational challenges such as the lack of fuel availability

and poor cash flow generation relative to assumptions made at the time of conception

have had a marked effect upon credit quality. 20% of loans to the sector have already been

restructured and Ind-Ra expects that the quantum of stressed loans could double over the next

two years. That being said, ultimate losses are expected to be low as projects still remain

viable, with cash flows expected to be generated over long useful-lives.

In the backdrop of tepid corporate loan demand, secured retail and SME assets have become

focus areas for banks to drive loan growth. Asset quality in these segments bears a strong link

to collateral values, a trend demonstrated in mid-2013 when high LTV gold loans witnessed a

spike in delinquencies. In case of a pronounced drop in property prices, loan quality may

also be tested due to the relatively higher leverage of retail borrowers property prices grew

faster than income levels in the past five years.

STRESS TOLERANCE CAPABILITY STILL ADEQUATE

Indian banks stress tolerance capability remains adequate, though marginally weaker as

compared to FY13 levels. At a system level, Ind-Ras stress test output does not anticipate


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any impairment of common equity capital. However, credit profiles of select government

banks remain vulnerable to elevated single-name and sector concentrations while some

private banks have created stronger buffers on improved funding from wider branch

expansion.

Figure 8: Stress Test Result of the Indian Banking System

Figure 9: Indian Banks: Stressed Credit Costs and Pre-Provision Profits


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Figure 10: Indian Banks: Post Stress Common Equity Tier 1 Capital

CAPITAL PLANNING CRITICAL

Capital requirements in FY15 for Indian banks appear to be modest, but demand for Tier 1

capital is expected to sharply accelerate from FY16. More than 90% of the banking system s

capital requirements for the Basel III transition will be due in FY16-FY18, as the need for

additional buffers for capital conservation and for systemically important banks, kicks in.

Figure 11: Govt. Banks: Capital Projections for Basel III Transition

Ind-Ra estimates total capital requirements for the Basel III transition to be INR5.2trn

(USD87bn). Of this, common equity is expected to constitute INR2.3trn (USD38bn), Tier 1

hybrids INR1.7trn (USD29bn) and Tier 2 subordinated debt INR1.2trn (USD20bn).

Government banks will require about 80% (USD70bn) of total capital issuances. Projections

assume additional buffers above minimum requirements of 1.5% for the five largest

government banks, and a buffer of 0.5% for all others.

Private Banks, based on their past track record of higher capitalisation and greater flexibility

to access capital markets are expected to maintain stronger capital buffers. Their currently


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solid capital levels mean that requirements are benign till FY17, with a sharp acceleration

anticipated in FY18.

Figure 12: Private Banks: Capital Projections for BASEL III Transition

The governments contribution in common equity injections for its banks is expected to be

USD23bn. Ind-Ra does not believe the quantum to be onerous for government finances, if

effectively spread out through the transition period. This would avoid crowding out in

later years. However, requirements could become taxing if state-owned banks with weak

standalone credit profiles are unable to sufficiently tap capital markets due to continually

subdued performance.

Equity injections from the capital markets are expected to total USD15bn, which is 2.5x the

equity raised by Indian banks in the previous five years (excluding injections by the

state - owned Life Insurance Corporation). The burden on the government and markets could

rise further if the domestic market for Basel III compliant Additional Tier 1 (AT1)

instruments does not adequately develop over the next two years.

AT1 instruments of banks with weak and volatile performance face higher risks of non-

performance through a coupon deferral and a principal loss at the breach of a pre-specified

trigger. The starting point in assessing the risks embedded in such an instrument is an

assessment of the banksunsupported credit profile. Any difference separating the hybrid

rating from the Issuer Long-Term Rating will depend upon Ind-Ras views on the volatility

of future performance and the likely need for extraordinary support to maintain the banks

viability.


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FUNDING CHALLENGES HAVE EASED,MAY RECUR

A drop in loan demand and a push from banks to increase the share of longer-tenor deposits

contributed to a general decline in asset liability mismatches (ALM) across banks. However,

the rising share of long-tenor assets (home loans and infrastructure) continues to keep gaps

high for government banks.

Figure 13: Ratio of Short-Term Funding Gap to Total Assets

Ind-Ra believes that government banks refinancing capability remains strong, based on the

strengths of their granular deposit bases and funding franchises. Banks with large ALM gaps

may however witness higher funding costs due to elevated refinancing pressure. This

compromises their capability to effectively transmit monetary easing and may exacerbate

pressure on margins in a declining rate environment. In the period of monetary easing

witnessed from early-2012 till mid-2013, base rate cuts of Indian banks were limited to 40bp

(as against a 125bp reduction in the repo rate).

ALM gaps could rise again in case of a sharp acceleration in loan growth. Retail liability

accretion may continue to trail loan growth if real interest rates continue to remain negative

for savers. Banks with an established presence in select large and fast-growing deposit

markets may be able to more effectively achieve retail and low-cost liability growth, enabling

them to better navigate challenges posed by such a scenario.


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Figure 14: Indian BanksRefinance Challenges

FY15PERFORMANCE:ANOTHER CHALLENGING FISCALThe profitability of Indian banks may witness another year of pressure as credit costs remain

elevated despite lower NPL accretions due to higher provisions for the aging stock of stressed

loans. One-time provisions for loans to borrowers vulnerable to currency volatility and higher

employee costs at government banks due to wage revisions and the resulting pension

obligations may also keep profits subdued. As banks compete for share in price-sensitive

retail loan markets, pressures on margins are also expected to sustain. Capital levels are

expected to remain stable despite the prospect of higher injections by the government

because of lower internal accruals and slightly higher loan growth.

PROBLEMS IN BANKING SECTOR

The banks in India face certain situations and issues with the system without any long term

non capital debt instrument. The problem has of recently gained more prominence and has

been figuring distinctively above the sea. There are various issues that need to be looked at to

understand the scenario in a better manner.

THE PROBLEM OF ASSET LIABILITY MISMATCH

The banking business is said to be inherently unstable. A bank takes deposits and then lends

the same money to borrowers at a rate of interest. It makes money on the interest margin that

it pays to the depositors and that it charges from the borrowers. However, for some reason, if

a large number of depositors wish to withdraw money at the same time, it will be impossible

for any bank to recall loans, and there could be a run on the bank. This is how banks used to

fail in the pre-central banking era. But that risk has now virtually gone as commercial bankshave unlimited liquidity support from the central bank of the country. Problems for banks can


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also arise because of the large and unmanageable mismatch between assets and liabilities,

termed as asset-liability mismatch.

What is it?

Asset-liability mismatch can arise if a significant part of the liability of a bank (read deposits)

is of shorter tenor and the assets (read loans) are of longer tenor. For example, if large part of

the deposits with a bank has a maturity of two-three years, and the bank lends that money to

an infrastructure company for, say, 20 years, there could be a payment crisis as the money is

locked with the borrower. A similar story is currently being played out in the Indian banking

sector. The growing divergence in the tenors of loans and deposits has resulted in rising

mismatches in the asset-liability statements of many banks, noted India Ratings and

Research, a rating agency, in a recent report. The rating agency further highlighted that

deposits maturing within one year constitutes 45% of the total deposits in 2013, up from 33%

in 2012. Since large part of the infrastructure finance in India is dependent on banks, they are

accumulating long-tenor assets. There are various implications of this mismatch. For

example, it puts pressure on the banking system to refinance its liabilities which is one of the

reasons why interest rates are not coming down despite policy rate cuts by the central bank.

The Way Out

In an ideal world, long-term assets should be financed by long-term funds. Therefore, it is

important that a country should have a vibrant bond market where, for example,

infrastructure companies can raise debt capital by issuing long-term bonds. Investors such as

pension funds, insurance companies, or individuals, looking for long-term assets can

participate in the bond market. Banks may also choose to buy these bonds. Since it will be

liquid market, banks can always sell bonds in the marketplace to generate cash in order to

meet payment liabilities and it will not be stuck with a particular part of its balance sheet for

the next 20 years like in the case of loans.

OVER DEPENDENCE ON SHORT-TERM FUNDING

The Indian banking systems dependence on short-term liabilities has grown to a point where

refinancing pressures are hurting margins. Deposits maturing within one year increased to

almost 50% of the total deposits in 2014, up from 33% in 2002. The ratio dipped in 2013

after growth in advances had moderated, before rising in 2014. A significant part of these

deposits had maturities within six months and, for some banks, included a growing share of

wholesale money market borrowings. The share has grown independent of the interest rate


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cycle and will likely be explained, paradoxically, as a strategy by banks to preserve margins

by remaining at the short end of liability tenor.

ALREADY LENGTHENING LOAN TENORS

The average loan tenor of most government banks has lengthened simultaneously with

shortening liabilities, driven by the rising share of long-term infrastructure and residential

mortgage loans. Loan growth in government banks was led by the infrastructure sector after

2008. This, together with residential mortgage loans (average loan tenors of over five years),

formed 25% of the banking systems loans in FY14.

POLICY CHALLENGES

Government banks dominate the Indian financial system, have preferential access to money

markets and can refinance debt without triggering a payment crisis. However, their growing

dependence on short-term funding poses unique policy challenges, including diluted

monetary transmission, a persistently flat-to-inverted yield curve and crowding out corporates

from the commercial paper market.

DILUTED MONETARY TRANSMISSION

Banks high refinancing velocity keeps their deposit costs elevated and dilutes their ability to

pass on monetary easing and reductions in repo rates to customers. This transmission bybanks is also lower than the downward shift in bond yields, making the debt capital market

more attractive than bank loans for better rated corporates. Largely Inverted Yield Curve: The

high level of short-term issuances led to the domestic yield curve being persistently flat to

inverted through most of FY13 and FY14, which is a disincentive for long-term savings. This

is unlikely to change unless issuance volumes shift to the long-end of the curve. Regulatory

initiatives that help banks address this challenge and push long-term savings will benefit the

economy in the long run.

THE PRE 2014 SCENARIO AND SOLUTIONS

LIMITED OPTIONS AVAILABLE TO BANKS

Banks had three possible options in addressing funding gaps. These include:

A bank can reduce its growth, especially in long-term assets such as infrastructure and

housing. However, this may prove difficult because of the governments focus and

the countrys requirement for accelerated long-term investment.


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A bank can plan to accrue long-term deposits. However, persistent high inflation has

led to low or negative real interest rates in the economy in the past few years and thus

slow deposit accretion, making this route also challenging. Also, the banking systems

long-term deposits (over three years maturity) are heavily concentrated (over 58%)

with the five largest government banks in India. Importantly, all these banks have

funding gaps lower than the banking system average. Therefore, banks with large

gaps, which tend to be most in the need of long-term deposits, find it difficult to

access them.

A more effective way to address this problem and improve the fundamental strength

of banks is through issuing long-term bonds. Banks so far had the option to issue Tier

II and perpetual bonds with Basel II features to mitigate some of these funding

challenges. Effective 1 April 2013, Basel III compliant bonds need to have more

stringent loss absorbing features, which may raise their cost substantially.

RBIGUIDELINES

Under the existing RBI guidelines, banks can issue only two types of long-term bonds

(i) capital qualifying (Tier 2 and additional Tier 1 under Basel III) and

(ii) infrastructure bonds up to the quantum of their infrastructure assets.

A market for Basel III compliant instruments with the going concern loss absorption

feature is non-existent in India. International experience suggests that the yields of Basel III

hybrids are at least four to five percentage points higher than the yields of senior debt.

Furthermore, investors in debt instruments are reluctant to invest in securities with quasi-

equity features. Hence, these instruments may not be an attractive option for raising long-

term funds by Indian banks. Also, there is a cap on the percentage of senior debt that can be

counted as capital. Banks have not approached capital markets with infrastructure bonds

despite RBI allowing banks to raise these to match their infrastructure portfolio. The appetite

has dampened as such instruments require features such as a minimum balance maturity

period for the underlying infrastructure assets. On the basis of its discussions with banks and

arrangers, Ind-Ra understands that the reluctance to issue these bonds may also have to do

with the concerns of higher pricing. The low demand may have been influenced by investors

being affected by the weak infrastructure sector and perhaps associating the risk on these

bonds with that of the infrastructure sector rather than with that of the issuing bank.


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SENIOR BONDS CAN BE THE ANSWER

Funding gaps can effectively be reduced by allowing banks to issue senior unsecured bonds,

which will not carry any capital credit. These bonds would be rated higher than most debt

capital instruments as there would be no subordination to senior creditors. These should,

arguably, obtain a finer pricing than even lower Tier II debt capital instruments prevalent

under Basel II. For banks that heavily rely on bulk deposits and certificates of deposit, the

cost of these bonds could actually be lower than the blended cost of these high-cost deposits.

Also, mid-sized banks with high concentration to infrastructure have the highest reliance on

bulk deposits and money market instruments. They, therefore, have the highest ALM gaps

among their peers, and long-term bonds would significantly aid their standalone credit

profiles by improving business competitiveness.

THE NEED FOR SENIOR BANK BONDS

Issuing senior bonds will improve the pricing of long-term assets as banks would be aware of

the precise cost of funding such assets improving their stress tolerance capability and

thereby their standalone credit profile. Also, once banks make available long-term funding to

infrastructure projects, their ratings could improve by virtue of financial rebalancing of

liabilities. This results in lower risk weights and therefore lower capital charge for

infrastructure projects in banks books. Thus, there is an indirect capital credi t that may

accrue to banks.

Features of Senior Bonds May Include:

a) Senior unsecured in nature

b)

Listed

c) Minimum maturity 15 years

d)

Maximum maturity 30 years

e)

No put call option before the minimum period

f) Coupon bearing or deep discount bonds (deep discount may attract retail

participation)

g)

Fixed or floating coupon

h) Caps on amount up to 10% of total liabilities. This would effectively replace volatile

high-cost liabilities on banks balance sheet


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i)

Eligible for investments by all onshore, including retail, and offshore investors,

including NRIs

j)

Reflected under heading of borrowings in banks balance sheet

Long-term investors such as pension funds and insurance companies have a limited appetite

for Basel III capital instruments, given the loss-absorbing and quasi-equity nature. Long-term

bonds provide good investment opportunity to these investors, given their long-term liability

profile. Therefore, LIC, EPFO, private insurance companies, PFs and FIIs will likely

participate and subscribe to these senior, unsecured bonds. Discussions with these investors

suggest a large appetite for highly rated longer dated debt instruments, not carrying any loss

absorption features.

POSITIVE FROM CAPITAL MARKET DEVELOPMENT PERSPECTIVE

In India, banks and financial institutions account for nearly 70% of the total non-government

bond issuances. The tenor of bank bonds has been generally 10 years, since these were lower

Tier II bonds under Basel II. The elongation of bond maturity by banks will help non-bank

issuers to start issuing longer dated instruments. Thus, a long-term yield curve can be

established by banks issuing longer dated instruments.

INTERNATIONAL EXPERIENCESMost developing and developed nations authorise banks to issue blocks of debt instruments

such as bank purchase orders, promissory bank notes or mid-term notes, zero coupon bonds

and bank debenture instruments. Post the sub-prime crisis, the US and EU regulators are

discussing laws that allow bailing in of senior creditors, which require their participation in

bank losses. Besides senior unsecured debt, several nations therefore are allowing their banks

to raise senior secured debt under covered bonds. However, senior secured debt (for example

covered bonds) may not be immediately applicable in a deposit-reliant banking system such

as India. This is because of legislative limitations and also since these could lead to losses for

depositors on liquidation.

SENIOR BONDS AND BANKING SCENARIO

Permitting banks to issue senior long-term bonds will help correct asset-liability mismatches

(ALMs) and provide a tool to improve liquidity coverage ratio by extending funding

outflows, says India Ratings and Research (Ind-Ra). Growing divergence in the tenors of

loans and deposits has resulted in rising ALMs in government banks.


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provide a tool to improve liquidity coverage ratio by extending funding outflows. Senior

bonds are rated at the same level as banks Long-Term Issuer Rating and are not notched like

loss-absorbing hybrid capital. Government banks have easy access to long-term investors

such as insurance and pension funds and hence are well placed to tap this market.

IMPROVING CREDIT PROFILE OF BANKS

For banks with vulnerable funding profiles, these bonds are a lifeline that can significantly

bring down refinancing risk, reduce the overall cost of borrowings and moderate volatility in

net interest margins (NIM). They provide greater flexibility while structuring long-term loan

products and will help price the tenor risk more appropriately than at present. We expect

these bonds to reduce the pressure to restructure delayed infrastructure projects by offering

realistic repayment schedules. Along with deleveraging under Basel 3, they can help improve

the stability in the banking system and benefit the standalone credit profile of banks over the

next five years.

BOOSTING THE LIQUIDITY COVERAGE RATIO

Yes, long-term senior bonds will boost the Liquidity Coverage Ratio by reducing short-term

outflow. The Indian banking systems dependence on short-term liabilities has grown

sharply. Deposits maturing within one year increased to almost 50% of the total deposits in

2014 (2002: 33%). A significant part of these deposits had maturities within six months,

which affects the Liquidity Coverage Ratio. Issuing long term bonds can smoothen outflow

and build up the Liquidity Coverage Ratio gradually.

THE IMPACT ON INTEREST RATE SENSITIVITY

Since these bonds will initially likely be fixed interest rate instruments, they will create a

basis risk if they fund variable-rate loans. The demand for floating rate bonds is limited, and

the domestic interest rate swap market may not be efficient while changing long-tenor

liabilities from fixed to floating. Ind-Ra believes the benefits that the bonds provide through

lower refinancing risk may balance any potential NIM compression in a falling interest rate

scenario. It is also possible that banks will offer fixed-rate loans to customers, which may

actually be attractive for infrastructure companies by eliminating interest rate risk.

RATING METHODOLOGY

Credit Rating agencies will rate the senior bank bonds at the same level as the banks issuer

rating, which is the higher of the support floor and the standalone credit profile of the bank.


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The RBIs circular on 15 July 2014 says that the bonds would rank pari -passu along with

other uninsured, unsecured creditors. While the circular does not explicitly mention the

seniority of these bonds over subordinated debt, it is obvious that they do not have any loss-

absorbing feature and are not debt capital instruments. These bonds will, therefore, be

equalised with the issuer rating, unlike the Basel 3 debt capital instruments which may be

notched down from the banks issuer rating depending upon their risk profile.

Thus for understanding the rating methodology to be adopted for rating these bonds, it is

essential to know the credit rating methodology adopted by rating agencies for banks.

MOODYS

GLOBAL BANK RATING METHODOLOGY

Moodys has developed its global rating methodology for rating banks. The rating has been

simplified and depicted as a three step process.

Figure 15: Moodys Global Bank Rating Methodology

The Three steps are as follows:

Determine the Bank Financial Strength Rating

Moodys BFsr reflects a banks intrinsic financial strength relative to all other rated banks globally.

These ratings are assigned from a thirteen point scale ranging from a to e (including + and -

qualifiers). There are five main factors for consideration:

1. Franchise value

2. risk positioning

3. regulatory environment

4. operating environment

5. Financial Fundamentals


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2

Translate the BFSR to a Baseline Credit Assessment

Once a BFSR is determined, its translated to a BCA on the Aaa to Ca scale (see Table 1).

Table 1 Source: Moodys

Consider Support Factors

To determine a banks final credit-risk rating, Moodys considers the possibility of support to a bankto prevent a default. The potential for support can reduce the credit risk of a bank, raising the deposit

rating above the BCA. This evaluation of potential support incorporates Joint-default analysis (JDA)

to adjust the BCA to a final deposit rating. in most cases, this will also be the senior debt rating.

Support may come from one or more of the sources listed below:

operating parent / shareholder support

cooperative / Mutualist Group support

regional / Local Government support

systemic support (national Government)

Understanding Moodys Ratings

Under Moodys three-step methodology there are a number of published ratings to consider.

Many market participants tend to focus on senior debt and deposit ratings, usually for foreign

currency obligations. Users of Moodys bank ratings may also look to the following to

understand better the specific risks and comparative strengths underlying a banks credit-risk

profile: Bank Financial Strength Rating, Local Currency Deposit Rating, and ForeignCurrency Ceilings.


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Subordinated debt, preferred stock, or hybrid instruments are typically assigned ratings one or

more notches below the senior debt and deposit ratings to reflect higher expected loss rates,

due to lower priority of claim.

Figure 16: Process of Bank Rating Building Source: Moodys

ICRA:CREDIT RATING METHODOLOGY FOR BANKS

CRAs rating assesses the credit risk of a bank which is a function of the business and

financial risk as well as the likelihood of external support available to the bank in case of any

financial stress. The report discusses the key parameters that ICRA uses for assessing the

business and financial risk of a bank. ICRA makes use of publicly available financial data as

well as the banks own statistical information for its credit evaluation. ICRA makes

appropriate adjustments to the financial data to ensure conformance with the generally

accepted accounting principles. The ratings are determined on a going concern basis rather

than on a mere assessment of the banks financials as on a particular date. The key factors

considered in the rating process are as follows:


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Business Risk

Operating and Regulatory Environment

Ownership Structure and Govt. Support

Governance Structure

Franchise

Management, Risk positioning, Systems and Strategy

Financial Risk

Asset Quality

Diversity of funding and Liquidity Profitability

Capital Adequacy

The above mentioned criterions shall now be dealt in detail.

Operating Environment

The assessment of a banks operating environment is one of the most important parameters

for the credit risk evaluation of a bank, as it could affect growth, asset quality and its

earnings. The operating environment of a bank is studied through an analysis of the

prevailing economic conditions; growth prospects (GDP growth rate); the likely deposits and

credit growth; structural constraints in the economy (such as a large fiscal deficit and the

necessity of banks to invest in Statutory Liquidity Ratio (SLR) papers) as well as the impact

of economic and regulatory environment on the credit risk profile. ICRA also evaluates the

likely policy changes to combat these challenges.

Regulatory Environment

A well regulated and supervised system is the backbone for credibility and stability of banks

even when the operating environment is unfavourable. ICRAs evaluation of the regulatory

system involves evaluation of norms related to capital and other countercyclical measures to

absorb risk, prevent related party transaction; the extent of regulatory supervision and

regulatory changes in the past in response to the macro environment; key norms (such as

NPA recognition, provisioning, capital adequacy, liquidity, expansion and directed lending)

and prospective regulatory changes (driven by financial sector reforms as well asinternational environment / leanings).


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Ownership Structure and Government Support

The Indian banking system consists of public sector banks, private sector banks, foreign

banks, cooperative banks and regional rural banks. While ICRA draws comfort from the

sovereign ownership of public sector banks, the credit view on some of the private sector

banks would depend on the ability of the bank to raise capital from promoters / other key

shareholders, as and when required. ICRA views positively a public sector bank with GOI

shareholding well in excess of 51%, as it would have greater flexibility to raise capital by

diluting GOIs shareholding.

Governance Structure

ICRA factors a banks governance structure in the rating process by conducting an

assessment of the structural and functional aspects of its Board and committees. ICRA

believes that an appropriate governance structure is important to ensure that banks operate

independently, with the interest of deposit holders not being compromised for other

stakeholders such as related party lending and lending to vulnerable sections. A good

governance structure also ensures that the powers given to line managers at a bank are

exercised in accordance with the established procedures and that these procedures conform to

the broad policy guidelines and strategic objectives of the bank.

Franchise

The franchise strength of a bank determines its capacity to grow while maintaining

reasonable risk adjusted returns and resilience of earnings. ICRA evaluates the franchise

strength of a bank in terms of scale of operations and market share for various activities at the

pan-India level or business niche; performance and strengths relative to competition;

complexity of key segments and special government support or privileges relative to other

banks. ICRA also takes into account the brand recognition, history and background of banks

under its franchise strength analysis.

Management, Systems and Strategy and Risk Management

ICRA lays special emphasis on governance issues; quality of management; systems and

policies; shareholder expectations; the strategy followed to manage these expectations and

accounting quality, as these aspects form the foundation of a banks credit risk profile. The

importance of these factors is even higher for a new bank or one with a shorter track record.

Usually, a detailed discussion is held with the banks management to understand its business

objectives, plans and strategies, views on past performance and outlook on the industry.


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Risk Management

A careful evaluation of the risk management policies of the bank is conducted, as it provides

an important guidance for the future liquidity, profitability, asset quality and capitalisation of

the bank concerned.

Financial Performance

Financial performance analysis is one of the key parameters used to compare a banks

performance over a period of time and across its peer group. ICRA conducts a detailed

financial analysis of the banks being rated. The key parameters that ICRA focusses on

include:

Asset Quality

Liquidity

Profitability

Capital Adequacy

Asset Quality

The asset quality of a bank is a reflection of its risk appetite; depth of its franchise and

effectiveness of its management, strategy, systems and processes. Asset quality holds the

potential to affect earnings (higher NPAs could dilute the yields and necessitate higher credit

provisions) and capital (lower earnings could slow down the internal capital generation or in

extreme situations (loss) could weaken the capital). The asset quality evaluation includes the

loan book as well as the non-SLR portfolio of a bank.

Diversity of Funding and Liquidity

ICRA conducts a study of the funding profile of the bank in terms of the sources and mix of

funds as well as the cost of funds to the bank, along the following lines:

Classification of deposits that is wholesale or retail: CDs and bulk deposits from the

corporate and institutional depositors are typically more volatile than retail and

household deposits. In its rating process. ICRA views positively a higher proportion

of retail deposits in the total mix. Demographic classification of deposits that is a

proportion of rural, urban and metropolitan deposits. Typically, rural deposits display

lower fluctuation than urban and metropolitan deposits, thus reflecting the lower


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availability of investment options as compared to the options available in urban and

metropolitan areas.

Cost of funds: The cost of funds is determined by the mix of deposits (current, savings

and time deposits), the tenure of deposits and the banks market standing that

influences its interest rate structure. Other factors include the banks reliance on

money market funding, (from call money markets, CDs, refinance lines and the like),

and the money market conditions prevalent and foreseen in future.

Payment services: The near-monopoly in operating the payment systems provides

banks a stable and low-cost base of settlement balances. ICRA assesses the banks

ability to offer value-added payment services (often driven by technology), which will

hold the key to a bank retaining the benefits from this natural service.

ICRA attempts to capture the liquidity of a bank by analysing the following qualitative and

quantitative parameters:

Market perceptions of the bank: Perceptions affect a banks ability to access funds

during a crisis. An indicator of such perceptions could be relative cost of funds for a

bank in the inter-bank market. The degree of the banks reliance on volatile funds in relation to total assets: Some

short-term funding sources are more sensitive than others to adverse developments.

ICRA views inter-bank funding by domestic banks and domestic deposits by non-

bank depositors in descending order of confidence.

Banks liquidity position: ICRA studies factors such as the overall match between the

maturity profile of its assets and liabilities; the level of readily saleable securities and

securities against which repo facilities are available. Committed lines of liquidity available that include revolving lines of credit and

refinance facilities

ICRA analyses the possibility of stakeholder support in case of a crisis. ICRA places

considerable emphasis on the implicit backing arising from the significant

shareholding of a strong entity in the bank. This benefit naturally accrues to all

nationalised banks, as the Government of India has demonstrated its support over the

years by infusion of equity or directed measures to bail out banks.


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Quality of capital and ability to raise capital: A higher percentage of core Tier I

capital is viewed more favourably, given its greater permanence, followed by hybrids

and subordinated bonds. In addition to these, ICRA evaluated the internal capital

generation capacity of the bank and the leeway available to augment capital to support

growth or withstand the stress.

CONCLUSION

The very starting point while analysing the effect of permitting banks to issue senior long-

term bonds, is that it will help correct asset-liability mismatches and provide a tool to

improve liquidity coverage ratio. Growing divergence in the tenors of loans and deposits has

resulted in rising Asset liability mismatches in government banks. For some banks, there is

even a shortage of ready collateral that could be used to repo with the Reserve Bank of India

in a liquidity squeeze, the credit rating agency.

Senior bonds are rated at the same level as banks Long-Term Issuer Rating in the absence of

a bank resolution regime and are not treated like loss-absorbing hybrid capital. Government

banks have easy access to long-term investors such as insurance and pension funds and hence

are well placed to tap this market. Senior bonds issued globally by Indian banks have a good

investor base. A similar, and possibly larger, market can be created among domestic

investors.

It goes without saying that investors take comfort from the benefits of government support,

which is reflected in Ind-Ras stable Long-Term Issuer Rating of government banks during

the economic slowdown in FY13 and FY14.

The existing guideline that permitted banks to issue infrastructure bonds did not find favour

with investors, perhaps due to the implicit link with a sector that has been struggling toperform for some time.

Further, the Indian banking systems dependence on short-term liabilities has grown to a

point where refinancing pressures are hurting margins. This also poses unique policy

challenges, including diluted monetary transmission, a persistently flat-to-inverted yield

curve and crowding out corporates from the commercial paper market. Credit rating agencies

have assessed that deposits maturing within one year have increased to almost 50% of the

total deposits in 2014, up from 33% in 2002. The ratio dipped in 2013 after growth in


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advances had moderated, before rising in 2014. A significant part of these deposits had

maturities within six months and, for some banks, included a growing share of wholesale

money market borrowings. The share has grown independent of the interest rate cycle and

will likely be explained, paradoxically, as a strategy by banks to preserve margins by

remaining at the short end of liability tenor.

It also has to be added that the domestic yield curve is likely to remain flat to inverted, unless

issuance volumes shift to the long-end of the curve. Regulatory initiatives that help banks

address this challenge and push long-term savings will benefit the economy in the long run.

Thus, with the arrival of senior bank bonds in the existing banking scenario, there are going

to be benefits in a wide range spectrum and as such the step will not just remain limited to

banking sector but the benefits are going to have a positive impact on the national economy

giving it a much needed boost.


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REFERENCES

GUIDELINES

RBI Guidelines on Asset-Liability Mismanagement System in Banks

REPORTS

Global Bank Rating Methodology, Moodys Investor Service (2008)

ICRA Rating Methodology for Banks, ICRA Limited (2011)

Ratings Direct: How We Rate Banks, Standard & Poors Rating Services (July 8th,

2013)

Special Report on Long Term Senior Bonds of Banks, India Ratings and Research

(July 24th, 2014)

Special Report on Senior Bonds: A Structural Fix for Banks, India Ratings and

Research (July 14th, 2014)

Outlook Report on 2014 Outlook: Indian Banks, India Ratings and Research (January

30th, 2014)

Special Report on Banking System: Wide Funding Gaps, India Ratings and Research

(January 24th, 2014)

Trends in the Global Banking Industry 2013, Capgemini (2013)

WEBSITES

lexicion.ft.com

treasury.worldbank.org

www.businesstoday.indiatoday.in

www.crisil.com

www.fitchratings.com

www.forbes.com

www.icra.in

www.investingbonds.com

www.investopedia.com

www.morganstanley.com


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www.standardandpoors.com

www.treasurydirect.gov

global senior bond rating

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