R&I Rating Methodology by Sector

Transcription

1 R&I Rating Methodology by Sector Depository Financial Institutions December 21, 2015 R&I applies its rating methodology for depository financial institutions to deposit-taking entities such as banks. Although used mainly for (1) financial institutions engaging in commercial banking activities, R&I also applies this methodology to (2) banking groups that offer a broad range of financial services including investment banking (universal banks and financial conglomerates at which at least two services from among banking, securities and insurance have equal or nearly equivalent weighting) and to (3) narrow banks that are developing only specific businesses from among traditional banking activities, such as settlement activities. Furthermore, although they have characteristics that differ from general financial institutions, R&I applies this rating methodology to cooperative and credit federation financial institutions and their central financial institutions. An additional evaluation framework for their unique characteristics is shown at the end of this report. I. Methodology to Reflect Special Government Support in Issuer Ratings In the case of banks, an R&I Issuer Rating reflects special government support. Such special support from the government has often been provided for banks, mainly for large-scale financial institutions. The reason given for such measures is systemic risk, the extremely large shock that is sometimes delivered to the financial system and general economy if systemically important financial functions are disrupted or have failed. The international trend, however, is toward arranging orderly resolutions for banks at the point of non-viability (PONV) without implementing special assistance, once systemically important financial functions have been protected. Banks are not well suited to general business failure workout laws grounded in legal procedures, and typically special laws for the resolution of financial institutions at PONV that are based on administrative procedures are applied. Deciding whether to reflect this special government support in bank ratings and the methodology for doing so can vary depending on the country. R&I evaluates governments intentions and their capacity to provide special support by separately examining parameters such as the regulatory and supervisory framework and authority, deposit insurance system, financial resources for support, resolution legislation and strategy for financial institutions at PONV, and the 1/13

2 bail-in policy (absorption of losses by parties such as shareholders and unsecured bondholders) in each country, and evaluating the parameters effectiveness. For deposits, a certain amount typically is protected by some framework such as deposit insurance, but the scope and effectiveness of the protection can vary according to country. The existence of the principle of depositor priority, and whether to make senior debt as well generally eligible for bail-in, also vary depending on the country. Senior debt normally is not explicitly granted protection through laws and regulations. In the case of countries where the protections for deposits and senior debt can be judged to be extremely strong, R&I will in some instances reflect special support from the government in its bank ratings. On the other hand, special government support is not reflected in the ratings of banks in countries where bank senior debt is covered across-the-board by a bail-in. Even when reflecting special government support in bank ratings, such support is in principle reflected only as a rating floor. R&I does not uplift the ratings of healthy banks that do not require special support from the government. II. Relationship to Sovereign Ratings During normal times, sovereign creditworthiness and bank creditworthiness do not move in tandem, but synchronization tends to rise rapidly during a crisis. Therefore in principle, the sovereign rating of the country where a bank is located acts as the upper bound for the bank s own rating. III. Evaluation of Business Risk 1. Industry risk Bank industry risk is inherently very high. This arises from the fact banks possess the following characteristics: (1) The effects of macroeconomic changes, particularly during difficult economic periods, are concentrated in the banking system and easily visible (2) As the principal entities responsible for the credit creation function they inherently maintain a high level of financial leverage (3) As the principal entities responsible for the duration change function they inherently have high liquidity risk It is possible to substantially lessen the industry risk, however, by creating and strengthening measures to contain the size of the inherently high industry risk. These include regulation and 2/13

3 supervision, a deposit insurance system, resolution legislation for banks at PONV, and a lender of last resort function (LLR) through the central bank. Specifically, these measures constituted the conditions of advanced country banking systems from the 1950s to the 1970s. The relative size of the industry risk will differ according to the strength of the framework to protect the banking system and the confidence of depositors and the market. Naturally there are differences depending on the country, and even within a country, differences arise from the degree of development of the systemic framework, the degree of confidence in the supervisory authorities and financial system conditions. With regard to regulation and supervision there is a propensity for a long-term trend to form in which they swing like a pendulum, moving between strengthening and easing. With the advance of deregulation and liberalization (capital movements, interest rates, scope of services) in industrialized countries after the 1970s, competition among banks intensified, and this became a factor that elevated industry risk. On the other hand, since the global financial crisis that erupted mainly in the United States and Europe in 2008, the trend has shifted in the direction of greatly strengthening regulation and supervision, a deposit insurance system, and resolution legislation for banks at PONV. As discussed above, the relative size of bank industry risk arises from factors such as the regulatory and supervisory framework, and varies in each country. In addition to this, when aspects of industry risk other than regulation and supervision are considered, except for certain wholesale activities the market in each country is segmentalized and has different industry risk, characterized with a strong local color. (1) Market size, market growth potential and market volatility Despite being smaller than the industry risk of other industries during normal periods, bank industry risk is strongly influenced by credit expansions and the formation and collapse of asset bubbles, both of which occur periodically, and is characterized by a tendency to rise sharply during a crisis. Consequently it is necessary to analyze the credit cycle and evaluate market distortions such as credit expansions or overheating and the effectiveness of authorities macro prudence policies. The expansion of credit normally is monitored using the ratio of credit to GDP. Because the level of the ratio of credit to GDP varies depending upon factors such as the structure and degree of development of the financial system in each country, there is no correct ratio that can be shared and applied globally. If the ratio of credit to GDP has changed as a trend when the stability of the ratio 3/13

4 was confirmed, it is necessary to ascertain carefully whether this is a sound structural change accompanying development of the financial system, or an unhealthy increase in the ratio originating in the expansion of credit. (2) Industry structure (competitive environment) Banks perform the functions of settlement, financial intermediation and risk management. In settlement operations, which have a strong public aspect as social infrastructure, they are required to provide low-cost, stable services. The industry structure and competitive environment differ considerably according to the country. R&I analyzes numerous factors such as the balance between indirect and direct financing, regulatory conditions including interest rates, scope of service and regulations on foreign ownership, the macro structure of the flow of funds, the composition and diversity of players in terms of state-owned banks, private sector banks and non-bank financial institutions, the degree of oligopoly by major financial groups, the distinctiveness/homogeneity of the players management strategies, financial products and services, differences in bankruptcy legislation, and the preparation and availability of credit information, and then finally, as the structure of the industry, evaluates whether an appropriate risk-return tradeoff is assured. (3) Customer continuity and stability In general, compared with other industries the risk of a bank s customers moving to another bank is somewhat small. While it might appear to be comparatively simple for customers to switch to another company because commercial banking activities do not result in sharp differences in products and services, customer continuity and stability are actually relatively stable. This is because continuous relationships are valued for corporate transactions though retaining customers is not easy in both individual and corporate markets. Individual customers rarely change their settlement accounts as well because of various reasons such as the complexity of the procedures. On the other hand, for certain wholesale activities such as investment banking, business relationships frequently change with each deal, and compared with commercial banking activities customer continuity and stability are somewhat low. (4) Protection, regulations and public aspects To assess protection and regulations, R&I studies the institutional design of the financial system, and the intentions and capabilities of the regulatory and supervisory authorities charged 4/13

5 with maintaining the system s health. Specifically, R&I evaluates the administrative measures to maintain soundness and prevent a crisis from occurring during normal times, and the responses taken by regulatory authorities if a crisis erupts. R&I assesses the risk of changes in regulations as well. For public aspects, which banks are asked by authorities and society to provide and that simultaneously are one of the grounds for protection and regulation, R&I investigates the effects these will have on a bank s business model and profitability. As regards frameworks for bank regulation/supervision and for resolution of banks at PONV, systems that ensure global consistency are being created. Although the effectiveness of such systems is guaranteed through equivalence assessment (peer review), some discretion will be allowed to each country s authorities. R&I therefore pays attention to and evaluates the differences arising from the discretion of each country s authorities. While some countries apply strict domestic standards where minimum required capital that exceeds the internationally agreed amount will be imposed, others adopt domestic standards that will be more lenient than regulations based on international agreements. Aspects such as the basic approach of each country s authorities and the grounds for their decisions, and the strength and sufficiency of protection, have to be studied individually. R&I also examines the scope of protection and regulation, authorities' view on special support, and the frameworks for cooperation and support among supervisory authorities in each country during the resolution of a cross-border bank. Other parameters, including macro-prudence policies and the implementation of Pillar 2 (financial institution self-management and supervisory review-based verification) since Basel II, early corrective measures, whether there is a system for capital injection different from the resolution system for financial institutions at PONV and the status of its actual implementation, and the thinking of authorities, must be considered as well. These have the effect of preventing healthy banks from becoming problem banks, and are a framework unique to regulated industries such as banking. Provided such parameters are functioning organically as a whole, R&I can evaluate banks as possessing characteristics that provide resistance against rating downgrades. By restricting the outflow of capital from an early stage, the capital buffer introduced in Basel III will substantively have the effect of accelerating the point at which authorities intervene in a bank compared with the exercise of early corrective measures, as well as the effect of enhancing the operational effectiveness of Pillar 2, and can be expected to increase banks ability to resist rating downgrades. If micro- and macro-prudence policies function effectively, there also is a possibility industry risk will be reduced, as the risk of a bubble forming is controlled and the expansion of bank size and complexity of risk are mitigated. The possibility of completely eliminating the risk of a 5/13

6 financial crisis occurring, however, even by strengthening macro-prudence policies, is low. Another characteristic is that there are many cases where forbearance policies (life-support measures) are adopted in the process by which banks are driven into a state of non-viability. During a crisis, authorities have a tendency to use expedients such as regulations, accounting and the tax system to ease problem loan certification criteria, the methodology for reflecting unrealized losses on negotiable securities, the definition of equity capital, etc. and to introduce policies that will temporarily avoid a bank falling into a state of non-viability. The actions of authorities are influenced by political circumstances at the time, however, and there are cases where a forbearance policy is temporary and the forbearance policy is suddenly waived, and the PONV acknowledgement is judged based on more exacting criteria. R&I will therefore make its rating evaluation by focusing on the actual conditions based on an assumption that no forbearance policies are in place. Industry risk of Japan s depository financial institutions Japan s depository financial institutions have low industry risk. Japan is an advanced country with a large-scale economy, and factors such as a business portfolio centered on commercial banking activities and the strength of the financial system safety net also contribute positively to this assessment. On the other hand, the projected long-term contraction of the market, the ongoing ultra-low interest environment, and the formation of an industry structure that makes it difficult to ensure an appropriate risk-return balance because of the severe competition resulting from oversupply and the progress of deregulation, are factors acting negatively on the industry. Because of historical circumstances, compared with other advanced countries, Japan is characterized by large share holdings by banks and a heavy reliance on indirect financing, even at large corporations. Japan is a large market. Nevertheless, growth potential is somewhat low, and there is a concern the market will contract as the population declines. Non-financial corporations as a whole have been in a chronic state of surplus funds. The scope of banking services has broadened with the progress of deregulation, however, and provided they can appropriately restructure their business portfolios, banks as a whole will be able to achieve the same level of growth as that of nominal GDP. The success or failure of banks development overseas will hold the key to whether they can achieve more rapid growth. Volatility is relatively low. As an advanced country, Japan has a mature financial system, and a business structure centered on the stock business of commercial banking activities contributes 6/13

7 to this situation. If the portfolio is diversified and appropriate risk management is in place, the business is highly stable. However, in addition to investment banking, the proportion of fees from flow businesses such as the sale of derivatives and financial instruments has been rising, and business volatility has also increased. The increase in the percentage of business in emerging countries, particularly in Asia, has become another factor amplifying business volatility. Competitive conditions are somewhat severe. Because of the extremely wide gap between deposits and loans, the lending market is under structurally intense supply pressure. Under the ongoing ultra-low interest environment, the spread on deposits is exceptionally thin as well. Added to these is the broad similarity in financial services and minimal differences in management strategies among banks. The severity of the competition tends to be linked to earnings deterioration, rather than changes in market share. Differentiation based on product characteristics and services is difficult, and a large market share does not necessarily translate into a strong ability to control prices. As an industry structure, such conditions can be said to have prolonged a situation that makes it difficult to ensure an appropriate balance of risk versus returns. Japan s financial system has a robust safety net. Deposit protection based on the Deposit Insurance Act and measures for responding to a financial crisis have been enhanced, and Japan possesses a performance track record. In addition to the existence of a framework for injecting public funds based on the Deposit Insurance Act, which is defined not to trigger a bail-in, the government is moving in the direction of developing a system for public funding injections in a timely and temporary manner. Entities such as government-affiliated financial institutions and credit guarantee corporations also provide a generous safety net function. 2. Individual firm risk (1) Value of the franchise R&I qualitatively evaluates a bank s capacity to stably report earnings in the future, i.e. its going concern value. R&I first examines the earnings opportunities and risk provided by the economic base in the bank s operating region and the markets where it operates that is, the potential value of the franchise. It then assesses the management capabilities and competitiveness that will enable the bank to use and actualize that potential franchise value as earnings. What is actualized is the value of the franchise, and this determines the framework of a bank s balance sheet structure and earnings structure. 7/13

8 (2) Risk profile and risk appetite R&I evaluates a bank's risk profile, which is the potential characteristics that will determine future changes in financial risk, its risk appetite the strength of a bank s risk-taking orientation and its capacity to control risks through a risk appetite framework (RAF), etc. The risk profile is examined from both aspects of business portfolio and balance sheet. IV. Evaluation of Financial Risk Because the values for quantitative evaluation yardsticks related to the following financial risks are set mainly by envisaging banks in Japan, certain adjustments are necessary when applying them to banks in countries other than Japan. In principle, when evaluating a bank in a country with relatively large industry risk (emerging countries, countries where the financial system is not mature, etc.), R&I makes its evaluation from a point of view that is more rigorous than the yardstick values used when evaluating banks in countries where industry risk is relatively small (advanced countries, countries where the financial system is mature, etc.). Furthermore, to comprehensively judge financial risks when there are indications the risks cannot be recognized or measured because of each country s regulations, institutional constraints, or restrictions on disclosures, etc., R&I will add the necessary adjustments based on other pertinent information. (1) Risk resilience A bank s capital is the definitive parameter supporting its solvency (solvency margin), and a shortage of capital, as well as of liquidity, becomes the final trigger for PONV. An evaluation of risk resilience assesses the sufficiency of capital from the viewpoint of the amount of the risk buffer, including capital, a bank maintains against the various risks (= economic capital) it faces as it develops its businesses. R&I also takes into consideration the sufficiency of parameters such as the common equity Tier 1 (CET1) ratio, which is the regulatory capital adequacy ratio, and the Tier 1 ratio and equity ratio. 1) Risk buffer against risk R&I s evaluation period for risk resilience is normally three years. That is, R&I assesses the sufficiency of capital by comparing a forecast of the various risks a bank might hold over three years with the projected risk buffer after three years. However, when evaluating a bank whose risk resilience is weak, R&I will also look at short-term risk resilience that is, compare the risks 8/13

9 envisaged over one year with the immediate risk buffer and will contemplate a reduction of its evaluation if there is considerable concern about capital adequacy. 2) Net risk monitored loans/tier 1 capital R&I analyzes the ratio of net risk monitored loans, defined as risk monitored loans minus the allowance for doubtful accounts, to Tier 1 capital. Loans that have become nonperforming are the biggest factor pushing a bank into a state of non-viability. While net risk monitored loans highlight the maximum loss that might be incurred from unreserved nonperforming loans, it is vitally necessary to understand the volume of such loans relative to Tier 1 capital. R&I positions this indicator as a supplement to the evaluation of risk resilience. 3) Risk and capital management structures In addition to a quantitative evaluation, R&I also evaluates from a qualitative perspective a bank s capacity to maintain its capital into the future. This includes verifying the bank s risk appetite framework, recovery plan, risk and capital management structures and financial flexibility. (2) Asset quality Deterioration in asset quality is linked directly with insufficient capital and is thus a leading cause of banks falling into a state of non-viability. R&I evaluates asset quality based on multiple factors, including (1) basic credit portfolio characteristics such as composition by asset type, by region and by industry, (2) stock indicators concerning asset quality (ratio of non-performing loans, ratio of classified loans, ratio of loans requiring caution, composition by obligor classification, composition by rating, reserve ratio, coverage ratio, etc.), (3) flow indicators concerning asset quality (credit cost ratio, patterns and trends in the occurrence of new non-performing loans, etc.) and (4) due diligence on large-sum borrowers and large-sum troubled borrowers. 1) Net risk monitored loans ratio R&I employs the ratio of net risk monitored loans (risk monitored loans minus the allowance for doubtful accounts) to the balance of loans minus the allowance for doubtful accounts as a typical stock indicator of asset quality. While it also confirms the ratio of risk monitored loans to loans (gross ratio), R&I s main focus is on the net ratio after deducting the allowance for doubtful accounts. 9/13

10 2) Rating distribution of the credit portfolio R&I evaluates the quality of the entire credit portfolio, including credits that are not classified in problem loans. For banks that are somewhat lenient in their self-assessment, R&I s evaluation encompasses an assessment of the rigor of internal ratings and self-assessment because credits sometimes contain substantial exposures to borrowers in the lower end of the normal category and other borrowers requiring caution (Other Watch Obligors). 3) Credit cost ratio (expected loss ratio) The credit cost ratio is the ratio of credit costs to loans/credits and is a typical flow indicator of asset quality. R&I comprehensively evaluates the average credit costs, their trends and the characteristics of changes in credit costs from both a management accounting and financial accounting perspective, giving consideration to the characteristics of the credit portfolio. 4) Rigor of asset assessment, loan loss reserve and coverage on loan claims To ascertain the reality of a bank s asset quality, when necessary R&I will perform due diligence to supplement its quantitative evaluation. (3) Earning capacity Banks require strong earning capacity, to absorb the credit costs that should be recognized as a bank management expense, accumulate internal reserves and expand capital. This makes the evaluation of earning capacity highly important, along with the evaluation of capital. 1) Operating profit margin before credit costs The ratio of operating profit before credit costs to total assets is a representative earning capacity indicator for looking at a bank s ability to primarily absorb credit costs. 2) Operating profit margin after credit costs This is the ratio of operating profit after credit costs to total assets. Because this figure is after the deduction of credit costs, for banks this ratio can be said to be an indicator that more clearly shows its primary earning capacity. Operating profit after credit costs is a bank s largest source of funds for continuously accumulating internal reserves. 10/13

11 3) Credit cost coverage ratio The credit cost coverage ratio is an indicator that looks at the degree to which credit costs can be covered with operating profit before credit costs. If this ratio is high, a bank can be said to have a strong capability to ensure its profit after credit costs. 4) Efficiency ratio The efficiency ratio is an indicator that highlights a bank s efficiency using a comparison of operating costs to gross operating profit. R&I combines this with an evaluation of the flexibility of the cost structure, analyzing whether a bank will be able to ensure a certain amount of earnings, even when its environment has deteriorated and revenues have declined sharply, by reducing expenditures. 5) Earnings quality, stability and diversity When evaluating earnings quality, R&I puts emphasis on more stable, high added value customer earnings (particularly earnings from core customers). Even if it earns a positive evaluation from a quantitative perspective, a bank that maintains strong earning capacity supported by the market sector will see its evaluation discounted from the qualitative aspects of its earnings quality. (4) Liquidity Together with capital, liquidity is emphasized as one of the final triggers that will cause a bank in a state of non-viability. When evaluating liquidity risk, R&I examines medium- to long-term structural factors, such as the composition of assets and liabilities and a funding structure, the adequacy of short-term liquidity, such as the level of the liquidity buffer under a stress environment, and the ability to access alternative liquidity including the central bank. 1) Loan-to-deposit ratio The loan-to-deposit ratio, which is simply a comparison of loans to deposits, is an indicator showing the extent to which illiquid loans are being covered by deposits, a highly stable method of funding. If this ratio is low, a bank can be said to have a strong tendency to ensure structurally sufficient liquidity. 11/13

12 2) Liquidity coverage ratio The liquidity coverage ratio is an indicator that shows whether a bank has sufficiently maintained assets that can be converted to cash within a short timeframe to provide funds to meet the capital outflows expected over 30 days under stress. If this ratio is high, a bank can be said to have adequate liquidity for the short term. 3) Deposit base and liquidity risk management structure Analysis of the deposit base, which is a bank s most stable source of funds, is indispensable for an evaluation of whether or not liquidity will dry up in the future. With regard to liquidity risk management measures, R&I confirms whether management systems have been appropriately prepared in response to the degree of funding stringency (during normal operating periods, periods of concern and in a crisis) and provide a structure enabling the bank to secure the necessary liquidity even under a stress environment, and whether the liquidity buffer is sufficient. V. Other Issues 1. Separate items noted when rating cooperative and credit federation financial institutions Cooperative and credit federation financial institutions are one type of depository financial institution, and the basic rating approach R&I utilizes is identical to that applied to banks. A number of aspects must be considered carefully, however, including (1) the fact they were formed as mutual aid and non-profit organizations is specified in their founding statutes, articles of incorporations, etc., (2) the various restrictions on their activities, (3) the presence of a central financial institution, (4) strong ties within each cooperative/credit federation financial institution industry (the industry) from an investment, financing and capital perspective, (5) the fact they have a unique safety net within the industry apart from the Deposit Insurance Act, among others, and (6) the exceptional measures taken, unlike general depository financial institutions, with regard to the handling of exemption items for funding within the industry (double gearing). 2. Separate items noted when rating central financial institutions for cooperative and credit federation financial institutions R&I's ratings of central financial institutions for cooperative and credit federation financial institutions are based on the evaluation of the entire industry, and also consider an evaluation of the central financial institution itself and the relationship between the central financial institution and the financial institutions within the industry. That is, R&I uses as a base an evaluation that 12/13

13 treats the entire industry as if it were one financial institution, and then supplements this with (1) capabilities for guidance and supervision of financial institutions in the industry by the central financial institution, (2) risk of support for financial institutions in the industry whose creditworthiness has weakened and (3) capacity of the central financial institution alone or the industry for absorbing support risk (e.g., room for capital increase), as well as financial flexibility and the feasibility of maintaining financial discipline. In its evaluation of the central financial institution as a stand-alone entity, R&I puts its emphasis on the appetite for market risk related to securities investment and on risk resilience. VI. Rating for Depository Financial Institutions Issuer Rating Individual Firm Risk Financial Risk Importance Indicators / Points of Evaluation Importance Value of the franchise Risk buffer against risk Risk profile and risk appetite Risk resilience Net risk monitored loans/tier 1 capital Risk and capital management structures Net risk monitored loans ratio Rating distribution of the credit portfolio Asset quality Credit cost ratio (expected loss ratio) Rigor of asset assessment, loan loss reserve and coverage on loan claims Operating profit margin before credit costs Operating profit margin after credit costs Earning capacity Credit cost coverage ratio Efficiency ratio Earnings quality, stability and diversity Loan-to-deposit ratio Liquidity Liquidity coverage ratio Deposit base and liquidity risk management structure Industry Risk: *Varies by country due to regulatory and supervisory frameworks, etc. In Japan, industry risk is low. Note) Importance is indicated by : extremely important, : important, or relatively important. * This report replaces all previous versions that have been released to date. The Rating Determination Policy and the Rating Methodologies R&I uses in connection with evaluation of creditworthiness (collectively, the "Rating Determination Policy and Methodologies") are R&I's opinions prepared based on R&I's own analysis and research, and R&I makes no representation or warranty, express or implied, as to the accuracy, timeliness, adequacy, completeness, merchantability, fitness for any particular purpose, or any other matter with respect to the Rating Determination Policy and Methodologies. Further, disclosure of the Rating Determination Policy and Methodologies by R&I does not constitute any form of advice regarding investment decisions or financial matters or comment on the suitability of any investment for any party. R&I is not liable in any way for any damage arising in respect of a user or other third party in relation to the content or the use of the Rating Determination Policy and Methodologies, regardless of the reason for the claim, and irrespective of negligence or fault of R&I. All rights and interests (including patent rights, copyrights, other intellectual property rights, and know-how) regarding the Rating Determination Policy and Methodologies belong to R&I. Use of the Rating Determination Policy and Methodologies, in whole or in part, for purposes beyond personal use (including reproducing, amending, sending, distributing, transferring, lending, translating, or adapting the information), and storing the Rating Determination Policy and Methodologies for subsequent use, is prohibited Japanese is the official language of this material and if there are any inconsistencies or discrepancies between the information written in Japanese and the information written in languages other than Japanese the information written in Japanese will take precedence. 13/13