External credit rating of bank credit: mandatory or essential?

The Basel Committee emphasises maintaining a minimum level of capital adequacy in banks. Basel framework states that banks can choose between two broad methodologies for calculating their risk-based capital requirements for credit risk. The first is the standardised approach (SA) and the other is the Internal Ratings-based Approach (IRB).In following SA, banks may use External Credit Assessment Institution (ECAI) as suggested by Basel framework. The essentiality of using ECAI(s) for bank loans needs a re-examination in consideration of alternative Internal Ratings-based (IRB) Approach, ECAIs' huge fee involved, bankers' time management, methodological pitfall, bias, and conflict of interest. It is necessary to review Bangladesh Bank's regulatory redundancy since nominating an ECAI is, as spelt out in Basel framework, not mandatory.

Risk-weighted assets (RWA) are the product of the risk weights, and the exposure amounts. Unlike standardised approach, banks can, under the IRB approach, use their internal rating systems for credit risk, subject to the approval of their respective supervisors. Moreover, banks can pursue either the advanced IRB approach (i.e. use their internal estimates of risk parameters such as probability of default (PD), loss-given-default (LGD) and exposure-at-default (EAD), or the foundation IRB approach (i.e. use only their internal estimates of PD).As the banks' internal system  provides the basic information which ECAIs use, external assessment  seems to be redundant. Instead, internal rating system may, if necessary, be further streamlined.

Bangladesh Bank has made it mandatory for banks to get their loans rated by ECAIs. Apart from entity credit ratings, all scheduled banks are required to nominate BB-recognised ECAI(s) for their own as well as their counterparty credit rating (Bangladesh Bank's BRPD Circular No. 7, September 23, 2008). Bangladesh Bank recognised eight credit rating agencies (CRAs) to provide rating services in Bangladesh. These CRAs are known as External Credit Assessment Institutions (ECAIs) both nationally and internationally. External Credit Assessment has been made in our country since 2012.In addition to aforesaid services, approved and recognized ECAIs offer a wide range of rating services.

What generic benefits are we reaping particularly from ECAIs' rating of our bank loans? We need to re-appraise the role of ECAIs in bank credit rating from the perspectives of huge fees involved and conflict of interest. Ratees of each credit exposure have to pay for rating. Here it is very natural that borrowers can try to influence rating agencies for having a good rating particularly in the context of Bangladesh. How far is it feasible to expect independent and unbiased rating? Besides this, external raters cannot take the responsibility of enforcing corrective action for any credit exposure poorly or adversely rated. It is those bank officials who are directly dealing with credit files to suitably suggest remedial measures. Qualitative analyses not backed by qualitative consideration cannot be indicative of reality. The goals and the values of ECAIs and the banks may not be congruent.

Is it possible for external   analysts to know and understand credit and borrowers' profiles more than the concerned officials who are in direct touch with the files and borrowers' behaviour as well as performance? It is learnt that they (ECAIs) collect basic data on borrowers and credit limit from the concerned bank officials. Do they cross-verify the data so obtained? It is not learnt categorically as to whether they have their own framework to independently justify the data obtained from banks or borrowers. Borrower-provided data are most likely to be biased. It is not usually possible to know the behaviour of a loan and borrowers without close and long time dealing of loans. Externally, that approach to monitoring is quite impossible. ECAIs' analytical tools may, no doubt, be sophisticated but are mainly based on secondary data.

It is observed from the websites of BB-recognised ECAIs that the methodology followed is not conceptually and practically clear, rather confused or overlapping with rating process as described in their literature. Particularly, the sources of data are not specified although several analytical tools are found in the reports.

The hard fact is that Bangladesh Bank makes it punitive for a bank (in terms of higher capital charge for any asset not rated) which remains unresponsive to rating any exposure. The bank has to face the capital shortage problem under minimum capital adequacy requirement. As banks have internal credit rating system, the need for external assessment is not comprehensible. Bankers' attention to core functions and duties is disrupted due to allocation of extra time for external credit rating agencies. Since there is an alternative approach to credit rating, i.e. IRB approach, Bangladesh Bank should not compel the banks to nominate ECAI (s) in return of huge fees involved. Fees of ECAIs raise the non-interest cost of loan or borrowers.

The Securities and Exchange Commission Bangladesh (SECB) framed Credit Rating Companies Rules, 1996 for investors' protection in issuing debt securities, and public issue of shares. Two domestic credit rating agencies (DCRAs) were licensed by SECB after 2002, which were later accorded status of external credit assessment institutions (ECAIs) by Bangladesh Bank. 

Thereafter, SECB and Bangladesh Bank issued rules and regulations towards mandatory ratings. SECB's initiatives and steps for ECAIs are undoubtedly crucial for protecting the investors' interest. But almost all external assessment of exposures of banks appears to be redundant. It is extremely necessary to strengthen the prevailing Internal Credit Risk Rating System.

In order to monitor the quality of rating, Bangladesh Bank has devised a process of mapping ECAI ratings against those of Standard & Poor's (S&P) and Moody's along with the Bangladesh Bank risk weight category. Reference to three most leading rating agencies may be made here. We are all aware of the Global Financial Crisis during 2007-2009 that centred on subprime securities (Mortgage Backed Securities- MBS). The three main rating agencies, Moody's, Standard & Poor's, and Fitch, have been scorned and vilified for their bad performance in rating subprime securities  (Clare Hill, Why Did Rating Agencies Do Such a Bad Job Rating Subprime Securities? University of Minnesota Law School, 2010).  As per Principle III.2 (Financial Stability Board), banks must not mechanistically rely on CRA ratings for assessing the creditworthiness of assets. This implies that banks should have the capability to conduct their own assessment of the creditworthiness, as well as other risks relating to the financial instruments, and should satisfy supervisors with that capability.

Planning for, and implementation of  any comprehensive directive must be done with a synthesis of  top-down as well as bottom-up approach (i.e. through the reciprocity of the central bank  and other banks' practical views). Bangladesh Bank as a central bank and national supervisor of the banking system should proceed to implement Basel's guidelines, suggestions or advice regarding capital adequacy, credit administration, and so on after an insightful and independent analysis.  

In adopting Basel guidelines for better conduct of banking operations, Basel framework points to supervisory review process too. What can incentivise us is that one of the basic functions of governance is to formulate or introduce  new policies, strategies, tactics, principles, and to  frame new rules, regulations, methods, procedures, techniques, etc so that organisational functions may be  performed with the  possible highest level  of  efficiency and effectiveness. From this perspective, the imperativeness of external rating of banks' credit exposures in particular needs to be reviewed holistically.  

Haradhan Sarker, PhD is ex-Financial Analyst, Sonali Bank & retired Professor of Management. sarkerh1958@gmail.com