R Gandhi: Growing NPAs in banks - efficacy of ratings accountability
and transparency of credit rating agencies
Speech by Mr R Gandhi, Deputy Governor of the Reserve Bank of India, at the Conference
conducted by ASSOCHAM (Associated Chambers of Commerce and Industry of India),
New Delhi, 31 May 2014.
* * *
Assistance provided by Shri D.R. Dogra and Shri Nethaji B is gratefully acknowledged.
Shri Jajodia, Shri Narang, Shri Dubey, Shri Kulkarni, Shri Dogra, Shri Khanna, Shri Pathak,
other distinguished speakers, Ladies and Gentlemen, a very good morning to everyone! To
start with I would like to commend ASSOCHAM for this seminar, for bringing together experts
from banking and rating industry, to discuss and debate upon this very pertinent and
challenging subject of NPAs and credit rating. A subject like this needs a lot of discussion
and thinking, because there are evidently no easy answers; if they existed, we would not be
in this state. In a way the last three years were wake-up calls for us; with the downturn in
economic activity, the cracks in our credit appraisal and monitoring system have appeared
and we should get our act together to repair the structures. This Conference provides an
opportunity to get additional insights into credit risk assessment and mitigation in addition to
getting to know the views of such a diverse and experienced panel of industry experts.
Asset quality
As the conference is being held in the context of growing non-performing assets (NPAs) of
Indian banks, let me begin with few statistics relating to NPAs to put things in perspective.
Before 2008, asset quality of SCBs was improving on a secular basis, following
implementation of Prudential Guidelines since mid 1990s. The GNPA ratio had declined
sharply from 12.0 per cent as at end March 2001 to 3.5 per cent as at end March 2006 and
thereafter this ratio was flat till March 2011. However, since then, the NPA of the banks has
been increasing; as at the end of Dec 2013, the Gross NPAs of the domestic banking system
was 4.40 per cent of Gross Advances. The final figure for Mar 2014 is yet to be known; While
some may view this ratio as reasonable given the economic conditions prevalent in the
country and elsewhere, the total stressed assets in the banking system (which includes
NPAs and restructured standard assets) as at Dec 2013 was 10.13 per cent of the gross
advances of the banks, which is a cause of concern for the Reserve Bank.
Why are NPAs increasing?
Growing NPAs is the biggest challenge for the banking industry. A slowing economy is bound
to see an increase in NPAs. Notwithstanding the economic weakness, the NPAs of banks
have registered increases since FY 2012 which is a cause of concern for us. The NPA
increases have been more pronounced in case of the public sector banks. There are various
factors affecting the asset quality of SCBs adversely, such as the current slowdown- global
and domestic, persistent policy logjams, delayed clearances of various projects, aggressive
expansion by corporate during the high growth phase etc. However, it is the shortcomings in
the credit appraisal, disbursal and recovery mechanism of the banks, besides the economic
slowdown that can in large part be held responsible for their high levels of NPAs. Lack of
robust verification and screening of application, absence of supervision following credit
disbursal and shortfalls in the recovery mechanism have led to the deterioration of asset
quality of these banks.
Credit ratings and asset quality
Let us now see the relationship between credit ratings and asset quality of the banks. Credit
ratings are forward looking opinion expressed by a credit rating agency on the ability and
willingness of a borrower to pay his dues in full and on time. More specifically, credit ratings
are relative ranking of borrowers based on the credit rating agency's assessment of
creditworthiness of the borrowers within a given universe. Credit ratings may also indicate
the credit risk associated with a specific credit facility or a specific security.
How does a credit rating differ from credit scores assigned by credit information companies?
Both credit rating and credit scores are a measure of credit risk and reflect the varying level
of probability of default of a given borrower. The difference is in the methodology used by
them to assess the credit risk. While credit ratings are forward looking opinion about credit
risk, credit scores assigned by credit bureaus are based on credit history of a borrower.
Credit ratings take into account the risk that a borrower may face during a given time horizon
in the future, whereas credit scores are based on the past performance of a borrower with
regard to servicing of debt. The second difference is that credit scores are assigned to a
particular borrower while credit ratings can be assigned to a specific facility.
While credit rating generally denotes a rating assigned by a credit rating agency, there is also
a mechanism of internal ratings by banks. A mechanism of internal credit rating of borrowers
was in existence in banks much before external credit rating of bank loans were introduced
under Basel II regulations. Reserve Bank's guidelines on "Risk Management Systems in
Banks" issued in October 1999, indicated that measurement of credit risk through credit
rating/scoring receive the top management's attention. Further, the "Guidance Note on Credit
Risk Management" issued in October 2002, stated that:
"A Credit-risk Rating Framework (CRF) is necessary to avoid the limitations
associated with a simplistic and broad classification of loans/exposures into a "good"
or a "bad" category. The CRF deploys a number/ alphabet/ symbol as a primary
summary indicator of risks associated with a credit exposure. Such a rating
framework is the basic module for developing a credit risk management system and
all advanced models/approaches are based on this structure......"
The credit rating assigned by a bank could be used for the following:
a. Individual credit selection - to decide whether to lend or not to a particular borrower.
b. Pricing (credit spread) and specific features of the loan facility - While risk based
pricing is an essential component of credit risk management, available evidence
suggest that competitive factors influence the pricing of a bank loan more than the
risk rating. However, for traded debt instruments, like commercial paper, there is still
link between rating and credit spreads.
c. Portfolio-level analysis.
d. Surveillance, monitoring and internal MIS.
e. Assessing the aggregate risk profile of bank/ lender. These would be relevant for
portfolio-level analysis. For instance, the spread of credit exposures across various
CRF categories, the mean and the standard deviation of losses occurring in each
CRF category and the overall migration of exposures would highlight the aggregated
credit-risk for the entire portfolio of the bank.
In line with Reserve Bank's guidelines, banks in India have put in place an internal credit
rating framework. Internal rating frameworks available with many of the banks are based on
solutions developed by external service providers. However, the effectiveness and
sophistication levels of internal rating framework vary from bank to bank. While difference of
opinion is essential to avoid "herding", large variance in ratings by banks using similar
models could put a question mark over the stability of the models or the ability of users to
use the models appropriately.
In addition to the internal credit rating framework, which are generally used to rate corporate
clients, banks also use simple credit scoring models to rate smaller borrowers and retail
borrowers. Credit scoring models for retail customers generally look at the following four
groups of indicators - demographic indicators, financial indicators, employment indicators
and behavioural indicators.
Since credit ratings/scores are a measure of credit risk, it has a strong link with NPAs. Loans
extended by banks are classified as NPAs when the bank considers that borrower has not
serviced his debt or is unlikely to service his debt as per the terms and conditions of the
contract. As such NPAs are manifestation of credit risk. Since credit ratings are relative
measure of credit risk, the likelihood of default of a borrower with a higher credit rating
should be lower than a borrower with a lower credit rating. As a corollary, a higher
proportion of borrowers with good credit rating in the books of a bank should translate into
lower level of NPAs. Whether that assertion is true or not requires us to evaluate the credit
ratings assigned by a credit rating agency by juxtaposing them against the actual default
experience.
Another important factor that needs to be kept in mind while comparing the ratings by a CRA
with that by a bank is what constitutes a "default"? Credit rating agencies recognise default
even if there is a default of one rupee or a delay of one day in servicing the scheduled debt
obligations. As far as banks are concerned, an asset is treated as non-performing asset only
when a scheduled payment remains overdue for a period of more than 90 days. The
definition of default is different as the purpose of recognition of default is different.
What should banks be doing ?
There is growing need for banks to strengthen their internal credit appraisal system i.e. on
their credit assessment and risk management mechanisms. At the same time, banks should
also consider using external credit appraisals in conjunction with their own assessment. This
would mean getting the house in order and at least on this score, banks would be on
stronger ground. Banks would still be vulnerable to other factors such as economic
slowdown, or policy changes or wilful defaults. But, one area of concern would be plugged.
This is where credit rating agencies can play an important role given their experience as well
as steady track record over the years.
Regulation of CRAs
In the Indian context, the general superintendence and regulation of credit rating agencies
are carried out by the SEBI under Securities and Exchange Board of India (Credit Rating
Agencies) Regulations, 1999. The regulations issued by SEBI cover various aspects viz.,
registration of rating agencies, fit and proper criteria for rating agencies, rating process and
methodology and its records, transparency and disclosures, avoidance of conflict of interest,
code of conduct, etc. While these regulations were initially applicable to rating of debt
securities by credit rating agencies, they have been extended to cover all rating activities
including bank loan ratings.
Additionally, the accreditation for a credit rating agency to qualify as an eligible External
Credit Assessment Institution under Basel II framework is issued by the Reserve Bank of
India. Such accreditation by the Reserve Bank of India is issued after evaluating a credit
rating agency's ability to adhere to the standards prescribed under the Basel II framework.
Reserve Bank of India has so far accredited six credit rating agencies viz., Crisil, ICRA,
CARE, India Ratings, Brickwork Ratings and SMERA Ratings. While accrediting credit rating
agencies Reserve Bank has been mindful of the need to have an optimum level of
competition in the ratings market.
In this regard, certain studies on effect of competition among credit rating agencies have
indicated that increased level of competition may lead to "rating shopping" and thus affect the
quality of ratings. Anil K Kashyap and Natalia Kovrijnykh (September 2013) have shown that
"...competition among CRAs causes them to reduce their fees, put in less effort, and thus
leads to less accurate ratings". However, in order to avoid predatory pricing, Reserve Bank
has mandated that credit rating agencies should disclose the nature of their compensation
arrangements with the rated entities on their websites. The disclosure should include the
minimum fee that a credit rating agency will charge and factors determining the fee
charged.
Credit rating agencies' eligibility is assessed against various qualitative and quantitative
parameters. These requirements are grouped into the following six criteria: Objectivity,
Independence, International access/Transparency, Disclosure, Resources, and Credibility.
Objectivity: Basel regulations prescribe that the methodology for assigning credit ratings
must be rigorous, systematic, and subject to some form of validation (back testing etc.)
based on historical experience. Further, the ratings should be subjected to continuous
surveillance.
Reserve Bank assesses this criteria in terms of factors like credit rating agency's definition of
default and action taken on default, historical default rates, ordinality of default rates (i.e.,
lower the rating higher the default probability), stability of the ratings (i.e., probability that a
given rating remain unchanged during a given period), predictive ability of the ratings,
improvement to the rating methodology to reflect current trends etc. Reserve Bank looks into
the default studies, transition matrices, Gini Coefficient etc. of credit rating agencies to
conduct the above assessment.
To ensure standardisation of default rates, the Reserve Bank of India has mandated that all
rating agencies shall use a uniform definition of default as far as the bank loan ratings are
concerned.
Independence: Basel norms state that a credit rating agency should be independent and not
subjected to political or economic pressures while rating. The rating process should also be
free from conflict of interest that may arise due to shareholding pattern or composition of
board of directors.
To assess whether a rating agency is independent, Reserve Bank of India evaluates the
ownership and organisation structure (presence of independent directors in the Board &
rating committees), Independence of individuals i.e. conflict of interest-between rating fee
and quality of ratings, conflict of interest with shareholders, conflict of interest at rating
committee level, separation of business development and rating activities, separation of
rating business from other business activities.
International Access / Transparency: Under this parameter, Reserve Bank evaluates
whether a credit rating agency makes necessary disclosures with regard to rating
methodologies and rating rationales to both domestic as well as international users without
any differentiation.
Disclosure: During the accreditation process, the Reserve Bank assesses whether a credit
rating agency makes the following disclosures: rating methodologies, including the definition
of default, the time horizon, and the meaning of each rating; the actual default rates
experienced in each rating category; and the transitions of the rating. In addition the
Securities and Exchange Board of India has also mandated a detailed set of disclosures by
credit rating agencies.
Resources: Access to sufficient resources is an important factor in determining a credit
rating agencies ability to furnish quality ratings. Reserve Bank makes an assessment as to
whether a credit rating agency has sufficient capabilities in terms of human resources i.e.,
number of employees, their qualifications and experience etc. Further, Reserve Bank also
looks into the technological capabilities of the credit rating agencies before deciding upon
their accreditation. In addition, Reserve Bank requires credit rating agencies to have access
to various sources of information on economy, sectors, companies, etc.
Credibility: Credibility of a rating agency is assessed based on the degree of acceptability of
ratings of a rating agency by independent parties viz., investors, insurers, trading partners
etc. Reserve Bank also looks into the internal procedures put in place by the credit rating
agencies to prevent misuse of confidential information acquired by them during their rating
exercise. Credit rating agency's adherence to code of conduct prescribed by Securities and
Exchange Board of India, International Organisation of Securities Commissions (IOSCO) and
Association of Credit Rating Agencies in Asia (ACRAA) are also analysed to determine the
credibility of a credit rating agency.
In addition to accrediting credit rating agencies, Basel II framework requires that the ratings
assigned by credit rating agencies shall be mapped to appropriate risk weights available
under the standardised risk weighting framework. Basel II framework requires that national
regulators should decide which rating categories correspond to which risk weights. The
mapping process should be objective and should result in a risk weight assignment
consistent with the level of credit risk reflected in the ratings. In India the Reserve Bank has
prescribed uniform risk weights for all rating agencies. Such uniform risk weights are
prescribed due to relatively low penetration of ratings and absence of sufficient historical
default data.
In addition to the detailed assessment at the time of accreditation, the Reserve Bank of India
also conducts an annual review of accreditation of credit rating agencies to assess their
eligibility for continued accreditation under Basel II framework. During the review exercise,
Reserve Bank evaluates the processes as well as the outcomes. The cumulative default
rates of rated portfolio of individual rating agency is evaluated in comparison with the
benchmark cumulative default rates proposed under the Basel II framework. The cumulative
default rates of the bank loan ratings in India are higher than the benchmarks provided by
Basel II framework.
How to merge banks credit appraisals and CRAs' assessments?
There are essentially four issues here where banks and CRAs need to work together which
will also help banks to de-risk their own portfolios as well as monitor their loans more
effectively.
First, Indian banks in conformity with the Basel II norms have been extensively using the
credit assessment opinion of external rating agencies for calculating risk based capital
requirements. Even though banks do not require credit rating by external rating agencies for
calculating their capital requirement for all loans (only loans above ₹ 10 crore require credit
rating), some are seemed to be asking companies to get a rating.This evidently is being done
to enhance their credit assessments. Quite clearly, there is recognition of the value brought
to the table by CRAs for banks which is being used for purposes beyond capital adequacy.
However, banks should take into account the cost to the companies and balance it against
the benefits.
We talk of sharing of credit information, which is vital given the frequent occurrence of
business cycles and their consequences. We have institutions called credit information
companies which provide such information to banks on the individual companies. Further, a
transition story of how ratings have been moving over time is also available which the
bankers should monitor and pick up and regularly draw a parallel rating map of CRAs which
they should compare with their own models and rating. This will be one useful check which
banks can create for their entire portfolio.
Second, I do see a lot of use in the products offered by CRAs and there is need to see how
we can further integrate the two models of credit risk assessment of banks and CRAs. There
is a suggestion that banks should de-risk their own portfolio by asking companies looking for
long term finance to partly borrow from the corporate debt market. This way the market
intelligence of CRAs which is mandatory for bond market borrowing would be an additional
input that would come in handy for banks when they are lending money to the entity. This is
even more pertinent today because of ALM issues and the demand for funds that would arise
once the economy picks up and infrastructure starts to boom. Banks may not be able to fully
meet the demand for funds to the borrowers. We have to start working out in detail the
implications of such a move, but in this forum it is worth germinating such a thought
considering that we have experts from both banks and CRAs present here.
Thirdly, one segment which particularly becomes vulnerable to economic shocks is the SME
segment. They are disadvantaged on account of their size and also are the first ones to get
affected when the downturn takes place. CRAs have models in place for rating of SMEs and
the NSIC scheme gives a subsidy to SMEs for the rating. It will be a good idea for banks to
require a rating from these SMEs before giving a loan so that there is a check in place before
the loan is disbursed. Given the large number of SMEs in our space, it may not be possible
for banks to do a due diligence for one and all. This is where the systems organized by CRAs
can be harnessed by banks so that there is some homework already done which is useful for
banks.
Fourth, as you may be aware, recently we have given guidelines on banks offering credit
enhancement on infra bonds issued subject to certain conditions. This is definitely one
measure that we would like to pursue which will also work towards developing the bond
market. At the same time, we see an important role for CRAs here too. This is an example of
a case of the bond market, banks and CRAs all working together for an optimal solution
which will finally benefit the economy.
The development of corporate bond market is very critical for leveraging the synergies
between banks and CRAs which can address the issue of growing NPAs in the system.
Therefore, I do see CRAs playing a very important role in the operations of banks that go
beyond just capital adequacy and Basel II. The final decision as well as the credit appraisal
has to be done by the bank and what the CRA provides will only be additional information
that can be used. Banks will also be looking towards the CRAs to shape up their capital
requirements under Basel III as they have to raise tier II bonds for shoring it up. But that will
be more as a market borrower rather than a lender.
Although the road has been set for Indian banks to migrate to an internal rating based
approach for evaluating their credit risk, the ability and preparedness of these banks to
migrate to the internal rating approach is expected to be contingent on banks being in a
position to test data based on the models to be used for this purpose. Banks would thus
necessarily have to rely on external credit ratings for their calculation of credit risk until all the
systems are in place.
Accountability of CRAs
Now let us look at the issue of accountability and transparency of credit rating agencies. Why
should there be accountability and transparency of credit rating agencies? This brings us to
the moot point of who pays for the credit ratings. There are two conventional models. These
are: "investor-pay" model, where the investor or banker commissions the credit rating and
"issuer-pay" model, where the issuer of the security or borrower pays for the rating. Of late, a
new model is being proposed: "society-pay" model, where a neutral third party, i.e.,
Government, Regulator etc., pays for the rating of a debt.
Each model has its own advantages and disadvantages. Let us analyse the "issuer-pay"
model further as that is the most prevalent model currently in our country. As said earlier, in
the issuer pay model, the issuer of the debt or the borrower commissions the credit rating
either voluntarily or to comply with regulatory requirement. In India, as far as public issue of
debt is concerned, regulations by the Securities and Exchange Board of India and Reserve
Bank of India make it mandatory for the issuers to obtain a credit rating. As far as the bank
loans are concerned there is no such mandatory requirement, even though the capital
requirements of banks with regard to corporate loans are dependent on credit ratings. Banks
may at their discretion require borrowers to obtain credit ratings.
The advantages of issuer-pay model is that, ratings once assigned and accepted, are
disclosed publicly and is available for users at free of charge. Small investors and individuals
who wish to invest in debt securities need not pay for accessing the credit ratings. Another
advantage of this model could be that issuers may be more forthcoming in sharing
information as they are the ones who have commissioned the rating. However, there is an
inherent conflict of interest in this model. Since the income and profits of credit rating
agencies are dependent upon the volume of ratings they assign, there may be a tendency to
assign inflated ratings to acquire and retain clients.
The Financial Crisis Inquiry Commission (2011, Page 212), which went into the causes of the
financial and economic crisis in the United States, has concluded that "....the business model
under which firms issuing securities paid for their ratings seriously undermined the quality
and integrity of those ratings; the rating agencies placed market share and profit
considerations above the quality and integrity of their ratings". Such conclusions on the
contribution of credit rating agencies to the recent financial crisis have led to calls for tougher
regulatory oversight on credit rating agencies.
To conclude, we can see that among the proactive steps that a bank can take to stem the
problem of increasing level of NPAs and stressed assets, use of credit ratings is an important
one. Banks can use the external ratings as third party, professional assessment, either as a
stand-alone basis or in combination with their own internal ratings. However, banks need to
balance the use of external ratings, as the recent financial crisis has highlighted the dangers
of over dependence on ratings.
I am sure today's deliberations will result in a lot of suggestions that can be used by
regulators like RBI and SEBI to bring in improvements in the policy frameworks. I look
forward to receive them from the organizers.
Thanking you all for your patient attention.