Regulatory Framework and Role of Domestic Credit Rating Agencies in Bangladesh

South Asia Working Paper Series
Regulatory Framework and Role of Domestic CreditRatingAgencies in Bangladesh

Jiro Tsunoda, Muzaffar Ahmed, and Mohammed Tajul Islam No. 21 | November 2013
ADB South Asia Working Paper Series
Regulatory Framework and Role of Domestic Credit Rating Agencies in Bangladesh

Jiro Tsunoda, Muzaffar Ahmed, and Mohammed Tajul Islam No. 21 November 2013
Jiro Tsunoda is principal portfolio management specialist, Asian Development Bank. Muzaffar Ahmed is president and CEO, Credit Rating Information and Services, Bangladesh. Mohammed Tajul Islam is vice president and head of ratings, Credit Rating Agency of Bangladesh.
Asian Development Bank 6 ADB Avenue, Mandaluyong City 1550 Metro Manila, Philippines www.adb.org 2013 by Asian Development Bank November 2013 Publication Stock No. WPS146204
The views expressed in this paper are those of the author and do not necessarily reflect the views and policies of the Asian Development Bank (ADB) or its Board of Governors or the governments they represent. ADB does not guarantee the accuracy of the data included in this publication and accepts no responsibility for any consequence of their use. By making any designation of or reference to a particular territory or geographic area, or by using the term country in this document, ADB does not intend to make any judgments as to the legal or other status of any territory or area. Note: In this publication, $ refers to US dollars.
The ADB South Asia Working Paper Series is a forum for ongoing and recently completed research and policy studies undertaken in ADB or on its behalf. The series is a new knowledge product and replaces the South Asia Economic Report and South Asia Occasional Paper Series. It is meant to enhance greater understanding of current important economic and development issues in South Asia, promote policy dialogue among stakeholders, and facilitate reforms and development management. The ADB South Asia Working Paper Series is a quick-disseminating, informal publication whose titles could subsequently be revised for publication as articles in professional journals or chapters in books. The series is maintained by the South Asia Department. The series will be made available on the ADB website and in hard copy.
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CONTENTS
I. II. III. IV. THE GENESIS OF DOMESTIC CREDIT RATING AGENCIES IN BANGLADESH CREDIT RATING AGENCIES IN BANGLADESH THAT ARE RECOGNIZED AS EXTERNAL CREDIT ASSESSMENT INSTITUTIONS BY BANGLADESH BANK HOW RATING AGENCIES ARE GOVERNED GLOBALLY REGULATORY FRAMEWORK FOR DOMESTIC CREDIT RATING AGENCIES IN BANGLADESH A. Credit Rating Companies Rules 1996 B. Dhaka Stock Exchange Direct Listing Rules C. Banking Regulation and Policy Department, Bangladesh Bank, Circular Number 05 Dated 29 May 2004 and Circular Number 06 Dated 13 March 2011 D. Guidelines of Bangladesh Bank for Capital Adequacy Framework and Accreditation of External Credit Assessment Institutions E. Circular of the Chief Controller of Insurance PERFORMANCE OF DOMESTIC CREDIT RATING AGENCIES IN BANGLADESH WITH REFERENCE TO THE ADB HANDBOOK ON BEST PRACTICE COMPLIANCE CREDIT INFORMATION BUREAU VERSUS CREDIT RATING AGENCY A. What Is a Credit Information Bureau? B. Credit Information Bureau in Bangladesh C. Regulatory Framework for the Credit Information Bureau in Bangladesh D. Credit Information Bureau versus Credit Rating Agencies IMPLEMENTING THE BASEL II GUIDELINES OF CAPITAL ADEQUACY FRAMEWORK FOR COMMERCIAL BANKS AND THE ROLE OF DOMESTIC CREDIT RATING AGENCIES A. Status of External Credit Assessment Institutions B. Monitoring and Mapping the Rating Quality of External Credit Assessment Institutions C. Risk Weight Assignment under Basel II and Prospects of External Credit Assessment Institutions D. Basel II Implementation: Bankers Challenges in Credit Risk Rating INTERNAL CREDIT RATINGS BY COMMERCIAL BANKS IN BANGLADESH PROSPECTS FOR CREDIT RATING IN BANGLADESH WITHIN A BASEL II REGIME BANGLADESH BANKS MOVE TOWARD RATING SMALL AND MEDIUM-SIZED ENTERPRISES CONCLUSIONS 1 2 3 3 3 4 4 5 5 6
V.
VI.
VII.
7 7 7 8 9 9
11 12 15 16 21 22 23 24
VIII. IX. X. XI.
APPENDIXES 1. 2. ADB Best Practice Handbook Credit Rating System Development for Small and Medium-sized Enterprises A. Background B. Inadequate FundingA Key Constraint to Growth of Small and Medium-sized Enterprises C. How Recognized Domestic Credit Rating Agencies Can Contribute to Credit Rating and Development of Small and Medium-sized Enterprises D. Mapping Rating Factors to Rating Categories E. Deriving Ratings through the Scorecard F. Proposal for a Rating Fund for Small and Medium-sized Enterprises G. How Would the Rating Fund for Small and Medium-sized Enterprises Bring Benefits for the Segment? 25 27 27 27 29 30 32 34 35
TABLES AND FIGURE

Tables 1 Road Map for Implementing the BASEL II Capital Adequacy Framework in Commercial Banks 2 Mapping of Bangladesh Banks Rating Grade with Rating Scales 3 Long-Run Reference 3-Year Cumulative Default Rate 4 Three-Year Cumulative Default Rate Benchmark 5 Risk Weights by Claim Type 6 Mapping the Ratings of Credit Rating Information and Services and Credit Rating Agency of Bangladesh on the Bangladesh Bank Rating Grade 7 Revised Mapping of Bangladesh Banks Rating Grade with Rating Scales 8 Number of Ratings by Rating Agency 9 Distribution of Ratings in 2012 by Long-Term Rating Notch 10 Distribution of Ratings in 2012 in Percentages 11 Distribution of Ratings in 2012 by Investment Grade Category 12 Banking Sector in Bangladesh 13 Categorization of Small and Medium-sized Enterprises in Bangladesh Appendix Tables A2.1 Proposed Rating Scale for Assessing Credit-Quality Ratings Assigned by a Domestic Credit Rating Agency to a Small or Medium-sized Enterprise A2.2 Rating Factors and Sub-Factors and Their Weights A2.3 Conversion of Factor Ratings into Numeric Values A2.4 Rating Scorecard for a Small or Medium-sized Enterprise A2.5 Factor Numeric Table of Small and Medium-sized Enterprises; 8-Notch Rating Scale Appendix Figure A2 Credit Rating Scheme in Bangladesh for Small and Medium-sized Enterprises
10 13 13 14 15 17 18 19 20 20 20 21 23 30 31 31 32 33
35
ABSTRACT
The Securities and Exchange Commission Bangladesh (SECB) promulgated the Credit Rating Companies Rules, 1996 for investor 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 which led to the building of information frameworks critical to the efficiency of financial markets. Investors could now optimize their riskreturn profiles, monitor their portfolios through regular surveillance and credit rating adjustments, and have timely information for trading and risk management. Recently, DCRAs have come to play a more crucial role since the capital adequacy of commercial banks has been tied to rating assessment of bank investments. The use of credit rating is expected to lead to the establishment of acceptable measures of credit risk evaluation so that commercial banks can meet Basel II regulatory prescriptions. As Bangladesh Bank accords ECAI status to more DCRAs, banking sector financing to corporate borrowers is receiving a boost. The number of DCRAs operational in Bangladesh has risen from two to seven between 2010 and 2013. Furthermore, Bangladesh Bank plans to introduce ratings for small and medium-sized enterprises (SMEs) and a customized credit assessment framework for SMEs including a separate rating scale and notation that sets SME ratings apart from the usual bank loan ratings. Access to adequate financing is still a chronic problem for SMEs in the Asian region and here, credit ratings could fill a critical gap in the credit information continuum, moving away from collateral-based lending to risk-based lending.
ABBREVIATIONS
ACRAA ACRL ACRSL ADB BCBS BRPD CAR CDR CIB CIR CRA CRAB CRC Rules 1996 CRG CRGM CRISL DCR DCRA DSCR EAD EBITDA ECAI ECRL FISL IDRA IOSCO IPO IRBA LGD LRA MARC MCR NBFI NCRL NRB NRSRO PACRA PSE RAM RBCA ROA RWA S&P SECB SMEs SMESPD Tk Turk Rating WCRCL Association of Credit Rating Agencies in Asia Alpha Credit Rating ARGUS Credit Rating Services Asian Development Bank Basel Committee on Banking Supervision Banking Regulation and Policy Department capital adequacy ratio cumulative default rate credit information bureau credit information report credit rating agency Credit Rating Agency of Bangladesh Credit Rating Companies Rules 1996 credit risk grading credit risk grading model Credit Rating Information and Services Duff and Phelps Credit Rating Company domestic credit rating agency debt service coverage ratio exposure at default earnings before interest, taxes, depreciation and amortization external credit assessment institution Emerging Credit Rating Financial Intelligence Services Insurance Development and Regulatory Authority Bangladesh International Organization of Securities Commissions initial public offerings internal rating based approach loss given to default lending risk analysis Malaysian Rating Corporation minimum capital requirement nonbank financial institutions National Credit Ratings nonresident Bangladeshi nationally recognized statistical rating organization Pakistan Credit Rating Agency public sector entities Rating Agency Malaysia risk based capital adequacy return on asset risk weighted amount Standard & Poors Securities and Exchange Commission of Bangladesh small and medium-sized enterprises Small and Medium Enterprises and Special Programmes Department taka (Bangladesh currency) Istanbul International Rating Services WASO Credit Rating Company (BD)
I.
THE GENESIS OF DOMESTIC CREDIT RATING AGENCIES IN BANGLADESH
1. The financial sector in Bangladesh consists of banks, nonbanking financial institutions (NBFIs), house-building financing companies, general insurance companies, life insurance companies, and a number of government-owned specialized institutions. In addition, the capital market of Bangladesh consists of a large number of institutions working under the regulatory umbrella of the Securities and Exchange Commission of Bangladesh (SECB). The spectrum also includes bonds and securities, mutual funds, the two bourses of the country, brokerage houses, merchant banks, and asset management companies. These institutions need the services of rating agencies as part of regulatory compliance and in many cases to use the same for business promotion and credibility enhancement. 2. In recognition of the importance of credit rating and its role in protecting the interests of investors in the capital market, the SECB formulated the Credit Rating Companies Rules 1996 (CRC Rules 1996) as a first step to ushering credit rating into Bangladesh. The above regulation provided that No issue of debt security or public issue of shares (including right shares at premium) shall be made by an issuer unless the issue is rated by a credit rating company and declaration about such rating is given in the offer document, prospectus or right share offer document as the case may be.1 3. In order to ensure appropriate quality of rating in the local market, the SECB compulsorily required domestic credit rating agencies (DCRAs) seeking licenses to have joint venture or technical collaboration with any established rating agency of international repute. 4. When Bangladesh Bank first issued a circular among rating agencies inviting expressions of interest towards being recognized as external credit assessment institutions (ECAIs), two rating agencies had presence in BangladeshCredit Rating Information and Services (CRISL) and the Credit Rating Agency of Bangladesh (CRAB). 5. Credit Rating Information and Services (CRISL) was the first rating agency in the country, set up in 1995 as a joint venture of Rating Agency Malaysia, JCR-VIS Credit Rating Company of Pakistan, and several financial institutions and professionals in Bangladesh. Credit Rating Information and Services was licensed by SECB to operate as a rating agency in the capital market in April 2002. 6. Credit Rating Agency of Bangladesh (CRAB) was established as a local rating agency in 2003. Based on its technical collaboration with ICRA, India, a subsidiary of Moodys Investors Service, United States, it was licensed by SECB in 2004. 7. As was mandatory under CRC Rules 1996, CRISL started rating a few listed banks while those banks were going for a rights offer of shares. The ratings created great sensation in banking circles and elicited interest among banking companies and regulators alike. Bangladesh Bank on 29 May 2004 issued a circular that made rating mandatory for all banks going public. It was envisioned that a banks rating report would help its investors remain better informed about the bank, promote transparency, and protect the interests of the depositors.2 In 2006 Bangladesh Bank issued another circular that made the annual credit rating mandatory for all banks, thereby embedding credit rating firmly into the banking process in Bangladesh.3
1 2 3
Notification No. SECB/Section 7/117, dated 24 June 1996. Bangladesh Bank Circular Letter No. 05, dated 29 May 2004. Bangladesh Bank Circular Letter No. BRPD 06, dated 5 July 2006.
ADB South Asia Working Paper Series No. 21
II.
CREDIT RATING AGENCIES IN BANGLADESH THAT ARE RECOGNIZED AS EXTERNAL CREDIT ASSESSMENT INSTITUTIONS BY BANGLADESH BANK
8. Credit Rating Information and Services. Credit Rating Information and Services was the first rating agency in Bangladesh, established in 1995 at the initiative of SECB. It was a joint venture between the Duff and Phelps Credit Rating Company (DCR) of Chicago and Rating Agency Malaysia (RAM) along with the Investment Corporation of Bangladesh and Prime Commercial Bank of Pakistan. While SECB took its time over issuing the license, DCR withdrew from the joint venture. After a long hiatus, CRISL was licensed by SECB in April 2002, taking into consideration its joint venture with Rating Agency Malaysia, Malaysia and DCR-VIS Credit Rating Company of Pakistan. Credit Rating Information and Services, with the support of its joint venture partners, has developed its own rating methodologies and database on various economic sectors to emerge as a reliable rating agency of the country. Credit Rating Information and Services is a founding member and signatory to the memorandum of the Association of Credit Rating Agencies in Asia (ACRAA). 9. Credit Rating Agency of Bangladesh. Credit Rating Agency of Bangladesh was established in 2003 and received license from SECB in 2004. The agency has technical collaboration with ICRA, India, a subsidiary of Moodys Investors Service, United States. Immediately after recognition, it became a member of ACRAA, which organized many seminars and best practice dialogues that also assisted CRAB in devising rating methodologies and developing technical staff. With individuals with distinguished service in high positions of public and private institutions on its rating committee, the agency brought into the rating system exemplary standards of integrity and external independent professional judgment of quality and reliability. A clear division of responsibility across the promoter-directors, rating committee members, and the professional staff members is maintained. 10. National Credit Ratings. National Credit Ratings (NCRL), a public limited company, started its operation with paid-up capital of 10.00 million taka (Tk) and got a license from SECB and subsequent ECAI status from Bangladesh Bank in 2010 with a technical collaboration agreement with the Pakistan Credit Rating Agency (PACRA), Pakistan. NCRL is a member of ACRAA. 11. Emerging Credit Rating. Emerging Credit Rating (ECRL) was incorporated in 2009 with technical collaboration of Malaysian Rating Corporation (MARC). It obtained a credit rating license from SECB and subsequent ECAI recognition from Bangladesh Bank in 2010. ECRL is a member of ACRAA. 12. ARGUS Credit Rating Services. ARGUS Credit Rating Services (ACRSL) is a joint venture between Singapore-based DP Information Group (experts in credit and equity research) and local sponsors with experience in capital markets. It was licensed by the SECB in 2011 and accredited with Bangladesh Bank as an ECAI in 2012. 13. Alpha Credit Rating. Alpha Credit Rating (ACRL) was incorporated in 2011 by a few distinguished and renowned professionals of Bangladesh with technical support from Istanbul International Rating Services (Turk Rating), a Turkish credit rating agency. It was licensed by SECB and granted ECAI status by Bangladesh Bank in 2012.
14. WASO Credit Rating Company (BD). WASO Credit Rating Company (BD) (WCRCL) started operations on 15 February 2012 with technical collaboration with Financial Intelligence Services (FISL), Hong Kong, China. It was given a license by SECB on 2 February 2012 and accreditation by Bangladesh Bank as an ECAI in October 2012. III. HOW RATING AGENCIES ARE GOVERNED GLOBALLY
15. Rating agencies globally are self-regulating organizations that enjoy the status of Nationally Recognized Statistical Rating Organization (NRSRO) from the regulators of the US. In Bangladesh, DCRAs have developed with financial and technical support of global rating agencies. In addition, the adoption of the Basel II frameworkwhich mandates that a DCRA must be recognized as an ECAI before its ratings are admitted for calculating capital adequacy of banking institutionshas rendered the rating agencies more transparent in terms of methodology, rating process, ethical code of conduct, and disclosure. 16. The code of conduct published by International Organization of Securities Commission (IOSCO) and its advisory to all member regulators to apply the code in their respective jurisdictions had a tremendous impact on reducing variability in functioning and quality of rating produced by agencies worldwide. 17. With the global economic meltdown in 2008, global rating agencies were strongly criticized for their failure to assess credit risks and probability of default properly. As a consequence, developed countries have imposed more stringent regulatory norms on the credit rating agencies (CRAs) in the recent past. In South Asia, however, DCRAs have been closely regulated from the outset. IV. REGULATORY FRAMEWORK FOR DOMESTIC CREDIT RATING AGENCIES IN BANGLADESH
18. Domestic CRAs in Bangladesh are operating within a regulatory framework put in place and monitored closely by the SECB. The framework is defined by a set of rulings that came into play at various points in time. A. Credit Rating Companies Rules 1996
19. The Credit Rating Companies Rules issued by SECB in 1996 created the umbrella of provisions under which the business of credit rating companies in Bangladesh is regulated, monitored, and controlled. 20. The CRC Rules 1996 provided in Section 3, Requirement of Credit rating: No issue of debt security or public issue of shares (including right share) at a premium shall be made by an issuer unless the issue is rated by a credit rating company and declaration of such rating is given in the prospectus or Right share offer document, as the case may be. 21. This made it mandatory for (i) all bonds, either public issues or private placements; (ii) issue of shares (equity) at premium in the capital market; and (iii) any right offer of shares at premium to be rated.
22. In line with the regulation, 93 issues were enlisted with the stock exchanges through initial public offerings (IPOs) between 2004 and 2013; on average, 10 IPOs came into the market every year.4 Of these, Credit Rating Agency of Bangladesh (CRAB) rated 49 issues, CRISL rated 36 issues, and the remaining 8 issues did not have any ratings.5 The trend shows that an average of 810 issues would come under purview of rating in a bid to comply with the regulation. 23. The bonds market in Bangladesh is still in its infancy with only three listed bonds, two of which are rated by CRISL and one by CRAB. In addition, there are some privately placed bonds and subordinated bonds that are under the rating fold. Six subordinated bonds issued by commercial banks and 30 bonds (zero coupon, securitization, preference share, and debenture) issued by corporate firms through private placement were rated by CRAB. But unless and until the market for structured products is developed the scope of rating will remain limited. B. Dhaka Stock Exchange Direct Listing Rules
24. The SECB initially allowed existing profitable and financially sound companies to sell some of the shares owned by the owners through direct listing with the stock exchanges in the hope that this would assist the companies in avoiding the lengthy process of IPO flotation. The preconditions for such direct listing, inter alia, included a condition that the company would carry at least a BBB rating from a recognized rating agency. 25. On the basis of the above regulation, which came into play on 12 April 2006, five stateowned and five private companies were listed on the Dhaka Stock Exchange during the period of 20062010. 6 Eight of these companies were rated by CRISL and two others by CRAB. 7 The state-owned companies were Desco, Power Grid, Jamuna Oil, Meghna Petroleum, and Titas Gas. The private companies were Shinepukur Ceramics, Khulna Power Company, Ocean Container, Navana CNG, and ACI Formulations. 26. This direct-listing method was strongly criticized as it was found to allow these firms to charge exorbitant prices against their shares. In the wake of the share market crash in 2010, the regulation has since been revoked. C. Banking Regulation and Policy Department, Bangladesh Bank, Circular Number 05 Dated 29 May 2004 and Circular Number 06 Dated 13 March 2011
27. Bangladesh Banks Banking Regulation and Policy Department (BRPD) issued a circular on 29 May 2004 to all unlisted banking companies to get them rated before they proceeded for IPO. The banks that were waiting to go public at that time did opt for the rating exercise before proceeding. Six banks, namely, BRAC Bank, Jamuna Bank, Trust Bank, the Premier Bank, Shahjalal Islami Bank, and First Security Bank, were listed in the exchanges through IPO. 8 Three of these were rated by CRAB and the rest by CRISL.9 In 2013, Bangladesh Bank granted eight more banking licenses. Rating agencies forecast that in the near future these eight banks may also be brought under the purview of annual rating.
4 5 6 7 8 9
Data sourced from www.dsebd.org As mentioned by the CRAB Office Research and CRISL Management. Data sourced from www.dsebd.org As mentioned by the CRAB Office Research and CRISL Management. Data sourced from www.dsebd.org As mentioned by the CRAB Office Research and CRISL Management.
28. The Insurance Development and Regulatory Authority (IDRA) is the primary regulator of insurance companies in Bangladesh. Nevertheless, another circular issued by Bangladesh Bank, BRPD 06 dated 13 March 2011, made it mandatory for general insurance companies to get themselves rated. Through the circular, all banks were instructed to consider the rating of general insurance companies instead of the relationship-based enlistment of eligible insurance companies to provide insurance/cover note to the bank clients. D. Guidelines of Bangladesh Bank for Capital Adequacy Framework and Accreditation of External Credit Assessment Institutions
29. Under the Capital Adequacy Framework for Commercial Banks under Basel II (which was adopted December 2007 and required full compliance by the banking sector in Bangladesh within January 2010), Bangladesh Bank has directed all commercial banks to nominate recognized ECAIs to rate the banks as well as their counterparties. Due weight has been given by ECAI ratings to capital adequacy. Unrated counterparties hence carry higher risk weight in capital adequacy determination, which works as an incentive to get the good clients rated. 30. As of 30 June 2013, Bangladesh Bank has recognized seven rating agencies as ECAIs: Credit Rating Information and Services (CRISL) and Credit Rating Agency of Bangladesh (CRAB) in 2009; National Credit Ratings (NCRL) and Emerging Credit Rating (ECRL) in 2010; and ARGUS Credit Rating Services (ACRSL), Alpha Credit Rating (ACRL), and WASO Credit Rating Company (BD) (WCRCL) in 2011 and 2012. E. Circular of the Chief Controller of Insurance
31. The Circular of the Chief Controller of Insurance No. 21/21/98-376 dated 12 March 2007 requires all general insurance companies to get rated once in a year and all life insurance companies, every 2 years, and also submit the rating report within 6 months of the completion of the financial year.10 As of December 2012, the number of insurance companies rated by different rating agencies was 31 by CRAB, 23 by CRISL, 3 by ECRL, 2 by NCRL, and 2 by Alpha.11 32. Initially, the IDRA was proactive in ensuring universal implementation and all insurance companies were rated. In subsequent years, the emphasis was somewhat diluted, rating agencies changed, and insurance companies slackened on renewal of rating. The outstanding ratings of insurance companies by rating agency as of 30 August 2013 are 20 by CRISL, 13 by CRAB, 4 by Alpha, 2 by ECRL, and 1 by NCRL.12 33. The Parliament of Bangladesh passed two insurance laws on 3 March 2010 in a bid to strengthen the regulatory framework and make the industry operationally vibrant. The new laws that came into effect on 18 March 2010 are the Insurance Act 2010 and IDRA 2010. The Insurance Act 2010 stated that the sector needs to be managed properly and then strengthened by reducing business risks; local and international insurance laws need to be reconciled and aligned so that the interests of the policy holders and other beneficiaries are protected.
10
11 12
The Chief Controller of Insurance is the erstwhile regulatory body for insurance companies in Bangladesh. Insurance companies are presently regulated by the Insurance Development and Regulatory Authority of Bangladesh or the IDRA. As mentioned by the CRAB Office Research. Data sourced from Dhaka Stock Exchange website. www.dsebd.org
34. Based on the new legislation, the Office of Chief Controller of Insurance was dissolved and the IDRA became the primary regulator of the insurance sector. As of December 2012, there are 62 insurance companies operating in the country, of which 43 general insurance companies and 17 life insurance companies belong to the private sector while only one general insurance company and one life insurance company belong to the public sector. All these firms are regulated under the comprehensive laws and guidelines of the IDRA. In 2013, the IDRA has approved 11 new insurance companies, of which two are general insurers while the remaining are life players. Ten out of these eleven already received licenses and the new insurers joined what several observers say is already a crowded field.13 35. A circular for yearly mandatory ratings of insurers was also taken forward, which stated that a life insurer was required to submit actuarial valuation reports on a yearly basis for the distribution of dividends. Therefore, life insurance ratings are also expected to be made mandatory on an annual basis. In addition, licensing of new insurance companies also increases the scale of insurance company ratings. 36. Like Bangladesh Bank, the IDRA is also planning to bring the rating agencies under its purview of regulation and supervision. A set of guidelines is being developed at the IDRA, which will have to be adhered to by credit rating companies that seek eligibility to conduct insurance sector rating, as well as minimum risk factors to be assessed for life and general insurance credit rating. V. PERFORMANCE OF DOMESTIC CREDIT RATING AGENCIES IN BANGLADESH WITH REFERENCE TO THE ADB HANDBOOK ON BEST PRACTICE COMPLIANCE
37. Of the seven DCRAs that have ECAI status in Bangladesh, CRISL, CRAB, NCRL, and ECRL are members of ACRAA barring ACRSL, ACRL, and WCRCL, which have been approved by Bangladesh Bank very recently. According to the best practice compliance survey conducted by the ACRAA Best Practice Committee in 2009, both CRISL and CRAB at this stage broadly comply with the ADB Handbook on Best Practices for CRAs (though the default statistics and transition metrics published by them are based on a small data pool).14 38. This is not surprising because CRISL was a founding member of ACRAA and its philosophy and methodology were developed around the practices established by its technical partners, initially DCR and later RAM. Credit Rating Agency of Bangladesh signed on to ACRAA immediately after it was floated. It tends to emulate CRISL in terms of operations with the technical support from ICRA. However, neither rating agency has the requisite research division, criterion handling capacity, infrastructure, training, or database management capabilities in line with reputed CRAs such as CRISIL or ICRA in India or RAM, Malaysia. This is because CRISL and CRAB in Bangladesh are still fledgling businesses with limited financial resources and small capital bases. 39. The remaining DCRAs in Bangladesh are newly formed and have been catching up to adopt the best practice handbook of ADB.
13 14
Data sourced from the IDRA Office. ADB prepared a handbook on international best practice in credit rating in December 2008 (Appendix 1).
40. The paid-up capital required for a DCRA to get a license in Bangladesh is Tk5.0 million, which is a meager amount compared with the size of operations of a DCRA. The capital requirement was fixed back in 1996 when there was no market of credit rating and there has been a sea change in the market scenario in the meanwhile. As more new licenses are issued, DCRAs are faced with fierce competition among the existing agencies putting their sustainability under a cloud. If rating agencies cannot sustain their business in the long run, there is an inherent risk of deterioration in the quality of ratings. 41. Furthermore, considering the economic scenario, poor disclosure in financials, taxation rules, government policy, regulations of central bank, poor bond market, equity-based capital market and above all, the newness and lack of understanding around credit rating, DCRAs in Bangladesh need to walk an extra mile to ensure an unbiased and robust ratings process. Instead of relying entirely on audit reports to assess a client, in most of the cases, DCRAs are required to probe beyond the audited figures to reveal the true state of affairs. For example, suppose the audited financials reveal that a client has never earned any profit during the last 10 years and capital is in the negative. Here the analyst in charge of the assessment needs to raise a flag on how and under what circumstances the client was able to pay all its loan installments in a timely fashion without a single instance of default. Such dichotomies need to be identified, highlighted, and investigated before a rating report is released. VI. A. CREDIT INFORMATION BUREAU VERSUS CREDIT RATING AGENCY What Is a Credit Information Bureau?
42. A credit information bureau is an entity that provides the credit history of a borrower in the form of a score based on various parameters. The main function of a credit information bureau is to provide information about the creditworthiness of a borrower. The bureau should be in a position to provide a credit information report (CIR), which is a factual record of a borrowers credit payment history compiled on the basis of information received from various credit institutions. Borrowers can also access their own credit report on payment of nominal fees. The bureaus functions include (among others) maintaining records of all credits, company information, country data on various economic activities, and corporate profiling of borrowers that access funds from lending institutions. B. Credit Information Bureau in Bangladesh
43. Bangladesh Bank, on 18 August 1992, set up a division called the Credit Information Bureau (CIB), which compiles the records of borrowers financed by banks and financial institutions controlled and regulated by Bangladesh Bank. It is responsible for collecting, processing, and maintaining an updated database of credit-related information supplied by borrowers for institutions that extend credit such as banks (Act 14, 1991), financial institutions (Act 27, 1993), House Building Finance Corporation (Presidential Order 7, 1973), and Investment Corporation of Bangladesh (ICB Order 40, 1976). 44. One of the objectives of setting up the CIB was to provide timely credit information about loan applicants in response to requests from banks and financial institutions so as to expedite loan applications and minimize risk of default. Bangladesh Bank recently automated the CIB system such that credit information in the CIB database can be updated round the clock. Online credit information is also available at the press of a button.
45. The database of the CIB contains detailed information on credit granted by participants (banks and financial institutions) to individuals, institutions, and organizations. The word credit information stands for any information relating to (i) the amounts and the nature of loans or advances and other credit facilities granted by a banking company to any borrower or class of borrowers, (ii) the nature of security taken from any borrower for credit facilities granted to him or her, and (iii) the guarantee furnished by a banking company for any of its customers. C. Regulatory Framework for the Credit Information Bureau in Bangladesh
46. The CIB is authorized to collect and provide data to financial institutions through a stipulation in Chapter IV on Collection and Furnishing of Credit Information of the Bangladesh Bank Order 1972, as amended. 47. Lending institutions are mandated to periodically report lending records by borrower in prescribed formats to the bureau. Before any loan is granted or renewed, the lending institution is supposed to compulsorily refer to the borrowers CIR from the central banks credit information division, which will indicate if the borrower has ever defaulted on or is currently in default with any other bank or NBFI. The CIR is not in the public domain and is available for reference only to banks and financial institutions under Bangladesh Bank. 48. Bangladesh Bank does not have any separate regulatory framework for the CIB in its present form as it operates as a division within the central bank. Existing regulations of Bangladesh Bank do not permit borrowers to access their own credit data but there is a clear process that enables borrowers to challenge incorrect information through their lenders. Within the legal framework that governs the CIB, the following principles are of paramount importance: (i) all participants (banks/financial institutions) are obliged to inform the CIB of their clients liabilities, (ii) the handling and circulation of individual information on a borrower is confidential, (iii) all participants have access to the information on a reciprocal basis, and (iv) all the borrowers have the right to request any participant (bank/financial institution) to rectify or update the liabilities. 49. While financial institutions are statutorily required to provide loan data, including information on collateral and guarantees to Bangladesh Bank, giving banks and financial institutions access to the total liabilities of each borrower in the CIB database, there are limits imposed on information that the central bank can further share with other lenders. Thus, although the information that there is a classified loan can be made available, the lending bank holding this classified loan cannot be identified. 50. It may be possible for a new borrower or organization to get a loan even though information related to it is not available in the CIB database. If information on individuals or organizations is available on the CIB database, this by itself poses no obstacle to getting a loan sanctioned. A loan stems from an agreement between the client and the bank/financial institution. 51. Any instance of default in the credit history of a borrower immediately debars it from further loans from any financial institution under Sections 27 KaKa and 5 GaGa of the Bank Company Act 1991 (Amended). Unless the default loan is adjusted, rescheduled, or declassified the borrower in question remains ineligible for loans or extensions on loans.
D.
Credit Information Bureau versus Credit Rating Agencies
52. As mentioned earlier, Bangladesh Bank does not have a separate regulatory framework for the CIB in its present form as it operates as a division within the central bank. 53. On the contrary, DCRAs in Bangladesh are regulated by the SECB through CRC Rules 1996. 54. The CIR neither expresses any opinion about the borrowers creditworthiness nor assigns any rating to the borrowers. It provides only the factual position of borrowers credit exposure as of a certain date presenting data of repayment of principle and interest based on past record. It also reports on the classification status of the borrower. The CIB does not have any data on a borrowers business operation. 55. Rating agencies on the contrary are required to maintain a database on the various economic sectors and corporate entities within each sector, particularly in the context of timely repayment of obligations. The database covers information on business operations, turnover, profitability, assets and liabilities, liquidity, long-term financing pattern, debt equity, and business prospects. The information is far more exhaustive than that presented in a CIR on credit history only. Rating agencies periodically update sector-specific data to determine sector-wise profitability, financing patterns, etc. This information is essential to rate a counterparty taking loan from any financial institution. 56. Credit ratings, thus, express an independent and objective opinion on the ability and willingness of an issuer to meet its financial obligations in accordance with credit terms of the initial contract. Instrument credit rating is an opinion on the probability that an issuer of a rated issue will pay interest and principal on time. Each rating category has a non-zero probability of default, including the highest one. Probability of default of a rating band may fluctuate over time on account of economic cycles and changes in risk profile of the relevant sector. Ratings are designed to be forward looking, even though groundwork analysis for credit ratings entails an appraisal of historical data. Thus ratings take into account the potential impact of future events on the issuers repayment ability. VII. IMPLEMENTING THE BASEL II GUIDELINES OF CAPITAL ADEQUACY FRAMEWORK FOR COMMERCIAL BANKS AND THE ROLE OF DOMESTIC CREDIT RATING AGENCIES
57. Bangladesh Bank, in line with international practice, issued a circular on 30 December 2007 towards the adoption of the Basel II Guidelines of Capital Adequacy Framework for Commercial Banks.15 Accordingly, Bangladesh Bank adopted the following implementation strategy: (i) (ii) (iii) standardized approach for calculating Risk Weighted Amount (RWA) against credit risk supported by ECAIs, standardized rule based approach against market risk, and basic indicator approach for operational risk.
15
BRPD Circular No. 14, 30 December 2007.
10
58. In order to implement the above, Bangladesh Bank issued a road map which has been presented in Table 1.16 Table 1: Road Map for Implementing the BASEL II Capital Adequacy Framework in Commercial Banks
Step of Activity/Action Fixing rules for recognition of External Credit Assessment Institutions (ECAIs) Consultation with stakeholders and issuing a circular on recognition of ratings by ECAIs and mapping of ratings with the appropriate risk weights Preparation of draft guidelines for Basel II implementation Description Developing guidelines for recognition of ECAIs Final approval of ECAI guidelines Last Date of Completing the Task 31 March 2008
31 May 2008
Issuance of circular on regulation for compliance of Basel II along with final guidelines and reporting format Parallel run of present regulation (Basel I) on Capital Adequacy and Basel II Accord
Developing database for switching to Internal Rating Based Approach (IRBA)
Migration to IRBA (Bangladesh Banks prior approval needed)
Preparation of draft guidelines with reporting format and publishing/circulating the same for appraisal of stakeholders Issuing detailed instructions to banks for implementation of Basel II and reporting the same to Bangladesh Bank regularly Banks to continue calculation of minimum capital requirement (MCR) as per existing regulation and simultaneous calculation of MCR under Basel II For calculating MCR under IRBA, banks will derive the figure for determining the probability of default on the basis of its own database and seek figure on loss given to default, exposure at default, and maturity of credit exposure from Bangladesh Bank. Thus, Bangladesh Bank will develop and maintain the required loss database to meet the requirements and banks will be prepared in this regard. Foundation IRBA both at the level of Bangladesh Bank and other banks run in parallel along with the standardized approach
31 August 2008
31 December 2008
1 January 2009 31 December 2009
By 2012
By 2012
59. The central bank has broadly succeeded in adhering to the time schedule above. Bangladesh Bank issued the Basel II Capital Adequacy Circular entitled Guidelines on Risk Based Capital Adequacy (RBCA) for Banks (Revised Regulatory Capital Framework in line with Basel II) on 31 December 2008 parallel to the existing BRPD Circular No. 10, dated 25 November 2002, which is basically introducing the requirement of Basel I.17
16 17
Ibid. Revised Capital Adequacy Guidelines dated 10 August 2010.
11
60. At the end of a parallel run, the Basel II regime came into force and the guidelines on RBCA were fully implemented from 1 January 2010 onwards with subsequent supplements and revisions. Instructions regarding minimum capital requirement (MCR) that scheduled banks needed to follow, along with the instructions contained in the revised guidelines on risk based capital adequacy for banks, were articulated with the following areas: (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) A. introduction and constituents of capital, credit risk, market risk, operational risk, supervisory review process, supervisory review evaluation process, market discipline, reporting formats, and annexure.
Status of External Credit Assessment Institutions
61. Under the standardized approach of the Risk Based Capital Adequacy Framework (Basel II), credit rating is determined on the basis of the risk profile assessed by the ECAIs recognized by Bangladesh Bank. All scheduled banks have been asked to nominate a recognized ECAI for their own credit rating as well as that of their counterparty. In this perspective, a set of guidelines regarding the recognition of eligible ECAIs was issued and forwarded to the scheduled banks. The Bangladesh Bank circular says, External Credit Assessment Institutions duly recognized by Bangladesh Bank will be engaged in credit risk assessment under the standardized approach of the Risk Based Capital Adequacy Framework (Basel II).18 On the basis of that assessment, risk weight will be mapped with the credit rating category and the risk weighted assets will be determined for calculating the capital requirement of banks against credit risk. The criteria of ECAI recognition and mapping process of risk weight has been developed in line with the International Convergence of Capital Measurement and Capital Standards (Basel II) issued by the Basel Committee on Banking Supervision (BCBS) in June 2006. The recognition criteria have been listed below. (i) Objectivity. The methodology for assigning credit assessments must be rigorous, systematic, and subject to validation based on historical experience. Moreover, assessments must be subject to ongoing review and responsive to changes in the financial condition of the concerned entity. An assessment methodology for each market segment, including rigorous back-testing, must be established for at least 1 year and preferably 3 years. Independence. An ECAI should be independent and free from political, social, or economic pressure that may influence the rating. The assessment process should also be free from any such constraint that could arise in situations where the composition of the board of directors or the shareholder structure and the officials of the assessment team of the ECAIs may be seen to create a conflict of interest. International access and transparency. The individual assessment should be available to both domestic and foreign institutions with legitimate interests, and at equivalent terms. In addition, the rating methodology used by the ECAI should be publicly available.
(ii)
(iii)
18
BRPD Circular No. 09, dated 31 December 2008.
12
(iv)
(v)
(vi)
Disclosure. An ECAI should disclose its assessment methodologies, notch or notation used, definition of the default rating category, the meaning of each rating and its time horizon, actual default rates experienced in each assessment category, and the transitions of the assessment, e.g., the likelihood of AA ratings becoming A over time. Resources. An ECAI should have sufficient resources to carry out high-quality credit assessment. These resources should allow for substantial ongoing contact with executives at both senior and operational levels within the rated entities in order to add value to the credit assessments. Such assessment methodologies should be based on both qualitative and quantitative approaches. Credibility. In addition to the above criteria, reliance on the credit assessment by independent parties (investors, insurers, trading partners) shall provide evidence of the credibility of the assessment of an ECAI. The credibility of an ECAI is also underpinned by the existence of effective internal control to prevent the misuse of confidential information. Monitoring and Mapping the Rating Quality of External Credit Assessment Institutions
B.
62. In order to monitor the quality of rating, Bangladesh Bank has devised a process of mapping ECAI ratings against those of Standard & Poors (S&P) and Moodys along with the Bangladesh Bank risk weight category (Table 2). 63. In order to comply with the principles of objectivity and consistency, quantitative data form the basis of the mapping process. Quantitative factors include long-term default rate associated with items that are assigned the same credit assessment. 64. Bangladesh Bank has mapped risk weight to the ECAIs rating categoriesdeciding which rating categories correspond to Bangladesh Banks corresponding risk weights category. Bangladesh Bank, in its BRPD Circular No. 05 dated 29 April 2009, circulated its first mapping of CRISL and CRAB ratings with Bangladesh Bank rating grade. The mapping of rating scales of six rating agencies with Bangladesh Bank rating grades has been revised with some modification and circulated, in its BRPD Circular No. 35 dated 29 December 2010, and subsequent inclusions are given in Table 2. 65. An ECAI rating has been mapped on grades 1 to 6, with 1 being the best and 6 being the worst and includes the Default Rating Category. Each short-term credit rating category can be evaluated and mapped against categories S1 to S6, with S1 being the best. Bangladesh Bank assigns risk weights on the basis of the evaluation of a variety of qualitative and quantitative factors relate to ECAIs rating category. 66. The consistency of an ECAIs rating category is determined through an analysis of the cumulative default rate (CDR) which is the measure of movement of a rating category into default rating during a specific time period.19 The indicators considered are (i) (ii)
19
10-year average of the 3-year CDR for evaluating the long-run default experience, and most recent 3-year CDR for evaluating the short-run default experience.
The definition of default rating has an impact on the assessment of CDR. External credit assessment institutions are expected to declare the definition of default rating on their websites and submit a copy to Bangladesh Bank. Subsequently, if any amendment on the same is made, it must be reported to Bangladesh Bank with due justification thereof.
13
67. The use of 3-year CDRs, evaluated over the longer term, and on an ongoing basis, is considered to provide an appropriate measure of the predictive power of credit assessments in relation to creditworthiness. Table 2: Mapping of Bangladesh Banks Rating Grade with Rating Scales
Bangladesh Equivalent Banks Rating of Rating S&P and Grade Fitch 1 AAA to AA 2 3 A BBB Long-Term Rating Category Mapping Equivalent Equivalent Equivalent Equivalent Notch/ Notch/ Notch/ Notch/ Notation of Notation of Notation Notation CRISL CRAB of NCRL of ECRL AAA AAA AAA AAA AA+, AA, AA+, AA, AA+, AA, AA1, AA2, AA AA AA AA3 A+, A, A A1, A2, A3 A+, A, A A+, A, A BBB+, BBB+, BBB+, BBB, BBB1, BBB, BBB, BBB BBB2, BBB BBB BBB3 BB+, BB, BB+, BB, BB+, BB, BB1, BB2, BB BB BB BB3 B+, B, B B+, B, B B+, B, B B1, B2, B3 CCC1, CCC+, CCC, CCC2, CCC CCC3 CC+, CC, CC CC C+, C, C, D C+, C, C, D C, D C, D Short-Term Rating Category Mapping ST-1 ST-1 N1 ST-2 ST-2 N2 ST-3 ST-3 N3 ST-4 ST-4 N4 ST-5, ST-6 ST-5, ST-6 N5 Equivalent Notch/ Notation of ACRSL AAA AA+, AA, AA A+, A, A BBB+, BBB, BBB BB+, BB, BB B+, B, B CC+, CC, CC Equivalent Notch/ Notation of ACRL AAA AA+, AA, AA A+, A, A BBB+, BBB, BBB BB+, BB, BB B+, B, B, CCC
Equivalent Rating of Moody's Aaa to Aa
A Baa
4 5
BB to B Below B
Ba to B Below B
C+, C, C, D
CC+, CC, CC, C+, C, C, D AR-1 AR-2 AR-3 AR-4 AR-5, AR-6
S1 S2 S3 S4 S5, S6
F1+ F1 F2 F3 B, C, D
P1 P2 P3 NP
ECRL-1 ECRL-2 ECRL-3 ECRL-4 D
ST-1 ST-2 ST-3 ST-4 ST-5, ST-6
ACRL = Alpha Credit Rating, ACRSL = ARGUS Credit Rating Services, CRAB = Credit Rating Agency of Bangladesh, CRISL = Credit Rating Information and Services, ECRL = Emerging Credit Rating, NCRL = National Credit Ratings, S&P = Standard & Poors.
68. Using the data provided by the ECAI, competent authorities will compare the most recent 10-year average of the 3-year CDR with the proposed long-run reference 3-year CDRs (Table 3).20 In general terms, the approach to mapping set out in the guidance provided by the Basel Committee is considered to represent the appropriate basis for mapping under these guidelines. It incorporates the use of 3-year CDRs together with qualitative analysis and appropriate flexibility of supervisory response. Table 3: Long-Run Reference 3-Year Cumulative Default Rate
Standard & Poors assessment Moodys 20 years average 3-year cumulative default rate AAAAA AaaAa 0.10% A A 0.25% BBB Baa 1.00% BB Ba 7.5% B B 20.00%
20
It should be noted that the numbers provided for the long-term benchmarks are mid-point numbers. Consequently, supervisory authorities will not expect the data provided by ECAIs to coincide exactly with these numbers.
14
69. The transition of an individual notch towards the default rating category observed in a particular ECAI rating category is compared with the standards available domestically, regionally, and internationally. Long-run transition towards default category of the ECAIs ratings will be compared with the reference values of CDRs available domestically, regionally, and internationally. In this connection, internationally accepted long-run reference values have been accepted by Bangladesh Bank. 70. Bangladesh Bank will use two benchmark CDRs, namely the monitoring level CDR and the trigger level CDR, for interpreting whether a CDR falls within an acceptable range for a rating category (Table 4). Table 4: Three-Year Cumulative Default Rate Benchmark
Standard & Poors assessment Moodys Monitoring level Trigger level AAAAA AaaAa 0.8% 1.2% A A 1.0% 1.3% BBB Baa 2.4% 3.0% BB Ba 11.0% 12.4% B B 28.6% 35.0%
71. Exceeding the monitoring level CDR benchmark implies that a rating agencys transition to default rating for a particular notch or notation is markedly higher than the domestic, regional, and international transition experience to default rating. A consultation process with the relevant ECAI will commence to understand why the default experience appears to be significantly worse. If Bangladesh Bank determines that the higher default experience is attributable to weaker standards in assessing credit risk, it would be expected to assign a higher risk category to ECAIs credit risk assessments. 72. Exceeding the trigger level benchmark implies that transition of an ECAIs notch or notation towards a default rating is considerably above the domestic, regional, and international standards. If the observed 3-year CDR exceeds the trigger level in 2 consecutive years, the ECAIs rating category shall be degraded. 73. External credit assessment institutions that have only a short record of transition and default data will be required to provide a projection of the 10-year average of the 3-year CDR on the basis of the two most recent CDRs. 74. Additionally, qualitative factors are also used by Bangladesh Bank to ensure comparability across data provided by different ECAIs. Qualitative factors consist of considerations such as the methodologies adopted by ECAIs, the pool of issuers that the ECAI covers, the range of transactions assessed, the meaning of each credit assessment, and the ECAIs definition of default. These parameters are important in the analysis of the transition and default data submitted by the ECAIs and the assessment of their performance against benchmarks. Where quantitative data is inconclusive for mapping risk weights, qualitative criteria may be the only basis.
15
C.
Risk Weight Assignment under Basel II and Prospects of External Credit Assessment Institutions
75. While issuing the circular on capital adequacy determination based on ECAI rating, the central bank has assigned extra risk weight to unrated clients. Furthermore, Bangladesh Bank has assigned lower risk weights to A (20%) and BBB (50%) rating categories. These two factors have together created a forced incentive within the banking community to utilize the services of ECAIs (Table 5). Table 5: Risk Weights by Claim Type
Bangladesh Banks Rating Grade 1 2, 3 4, 5 6 Unrated 1 Risk Weight % under Basel II 20 50 100 150 50 20 Fixed Risk Weight under Basel I Remarks 50 Need rating to reduce risk weight 50 50 50 50 20 Need rating to reduce risk weight
Exposure Type Claims on public sector entities (excluding equity exposure) Claims on banks and nonbank financial intermediaries (original maturity over 3 months)
Claims on corporate
2, 3 4, 5 6 Unrated 1 2 3, 4 5, 6 Unrated
50 100 150 100 20 50 100 150 125
20 20 20 20 100 100 100 100 100
Need rating to reduce risk weight
Need rating to reduce risk weight Need rating to reduce risk weight Need rating to reduce risk weight Discourage unrated client
76. Bangladesh Bank has assigned different risk weights in line with Basel II to the claims on (i) public sector enterprises, (ii) banks and NBFIs, and (iii) corporate firms. Again, these Bangladesh Bank risk categories have been linked with the ECAI rating categories as the primary principle of risk categorization. Except for fixed risk categories, the ECAI ratings have so far been recognized as the benchmark for risk identification and for determining levels of risk to be assigned within the capital adequacy framework to banks and NBFIs. 77. Under Basel I, implemented in Bangladesh in 1996, all interbank lending was risk weighted at 20% for capital adequacy determination. With the implementation of Basel II, all banks are required to rate interbank lending in order to determine the real risk weight, so banks in Bangladesh are now using the ECAI ratings to determine capital adequacy against interbank lending. 78. Under Basel I, all private sector financings attract 100% risk weight. Under Basel II, all unrated financings attract 125% risk weight with a deleterious impact on capital adequacy. It has been observed that although the capital adequacy norm of 10% of all risk weighted
16
assets remains unchanged across Basel I and II, with the implementation of Basel II, the capital adequacy ratio (CAR) for most banks fell by at least 3%, and unrated clients have contributed significantly towards this reduction. 79. In India, mandatory provision of 150% risk weight for unrated clients has ensured that rating agencies recognized as ECAI contribute significantly to the economymost of the clients are now rated and the surveillance of ratings continues to provide a bank the comfort of risk categorization in its own portfolio. On the contrary, in Pakistan there has been no significant impact on Basel II implementation since the unrated clients are still assigned a 100% risk weight as was the practice under Basel I. 80. With 125% risk weight assigned to unrated private lending in Bangladesh (a moderate approach that lies between Pakistans 100% and Indias 150%), the banks are now seriously persuading and incentivizing clients, especially good clients, to opt for rating. 81. Bangladesh Bank has clearly entered the Basel II regime and ECAI ratings can be expected to continue to play a positive role in risk categorization of bank portfolios. D. Basel II Implementation: Bankers Challenges in Credit Risk Rating
82. Bangladesh Bank, in its Circular No. 9 dated 31 December 2008, instructed all commercial banks to maintain capital adequacy under Basel II after a parallel run of 1 year. The primary purpose is to ensure that banks henceforth maintain capital adequacy against not just credit risk but also operational and market risk. Banks are asked to calculate the credit risk on the basis of the credit rating assigned by ECAIs and by mapping the rating against Bangladesh Banks risk weights both in the case of long-term as well as short-term ratings. Unrated clients attract a fixed risk weight of 125%. 83. In implementing the Basel II framework for capital adequacy, bankers in Bangladesh were faced with the following challenges: (i) (ii) (iii) (iv) Since most of the banks were operating at the minimum capital level to begin with, additional capital required to cover market and operational risks was hard to come by, thus pushing the CAR below the minimum acceptable level. Since almost all clients in the portfolio were unrated, risk weights across the board increased from 100% (under Basel I) to 125%. Most state-owned commercial banks provided finance to the (generally unrated) public sector entities, which now attracted a 50% risk weight under Basel II as opposed to 20% under Basel I. Clients were not interested in opting for rating and banks lived in the fear of losing loyal clients.
84. In view of the fact that, with Basel II, the overall CAR has decreased by 3.0%3.5% across banks and bankers are unable to cope in the short run, the regulators have temporarily reduced the capital adequacy requirement from 10% of all risk weighted assets to 8% with the understanding that banks will be able to convince their clients to get themselves rated. It is expected that within a 2-year period, it will be possible to reinstate the capital adequacy norm of 10% without all banks going under. In this context, some private sector banks have been vigorously trying to get their clients rated in the shortest possible time.
17
85. Banks that are now convinced of the importance of rating view it as a tool that enables new/further financing. They are starting to reap other advantages of servicing rated clients as well. Rating gives the banks insight into the financial health of the clients. They are better informed about the sectors they are financing. Ongoing or renewed rating reports are important when applications for further financing are assessed. During January 2011November 2011, banks therefore have been actively encouraging their clients to get rated. 86. Notwithstanding the clear advantages of rating mentioned above, bankers that have succeeded in persuading a larger number of clients to get rated, are still not getting desired results in terms of capital adequacy. This is despite the fact that the ratings being assigned to the clients by the ECAIs are more or less in line with the banks perception of the clients creditworthiness. The reason for this lies in the flawed mapping of ECAI ratings on the Bangladesh Bank risk-rating scales in the long term (Table 6).21 Table 6: Mapping the Ratings of Credit Rating Information and Services and Credit Rating Agency of Bangladesh on the Bangladesh Bank Rating Grade
Bangladesh Bank Rating Grade 1 2 3 4 5 6 S1 S2 S3 S4 S5 S6 Risk Weight % 20 50 50/100a 100 100/150b 150 20 50 50 100 100 150 Equivalent Rating of CRISL AAA AA+, AA AA, A+, A, A BBB+, BBB, BBB BB+, BB, BB, B+B, BCCC+, CCC, CCC, and below CC+ and below Short-Term Rating Category Mapping ST-1 ST-2 ST-3 ST-4 ST-5 ST-6 Equivalent Rating of CRAB AAA AA1, AA2 AA3, A1, A2 BBB1, BBB2, BBB3 BB1, BB2, BB3, CCC1, CCC2 CCC3 and below ST-1 ST-2 ST-3 ST-4 ST-5 ST-6
CRAB = Credit Rating Agency of Bangladesh, CRISL = Credit Rating Information and Services. Notes: a 50 for banks and 100 for corporates. b 100 for banks and 150 for corporates.
87. It is observed from Table 6 that all ratings ranging from AA (implying high safety) to BBB (implying the low end of moderate safety) are lumped in the same risk categorybanks are dragged down by the weight if even the relatively good A-rated clients are mapped with a 100% risk weight. In both the rating scale of CRISL and CRAB, risk levels in the rating scale AA/AA3 to BBB/BBB3 display wide variations. 88. It is observed from Table 6 that the initial mapping of Bangladesh Banks risk weight on the ECAI rating places AA/AA3 (means high safety) to BBB/BBB3 (means lower of moderate safety) in the same risk category.
21
BRPD Circular No. 5, dated 29 April 2009.
18
89. If one were to compare Tables 5 and 6 to Table 7, some significant aspects are revealed: (i) Grade 3 enterprises on the Bangladesh Banks risk scale attract a risk weight of 100% if they are corporate firms and 50% if they are PSEs or banks. In fact AA (high safety) and A+, A, A (adequate safety) ratings fall within Grade 3. On the contrary in the original Basel document, AA ratings carries 20% risk weight while A ratings carry 50% risk weight. Grade 5 enterprises on the Bangladesh Banks risk scale which attract a risk weight of 150% if they are corporate firms and 100% if they are public sector entities (PSEs) or banks. In the Basel document, these are mandated to carry 100% risk weight. The Basel document suggests a 50% risk weight for all A-rated enterprises whereas Bangladesh Bank places only AA+ and AA under 50% risk weight category As a consequence, some high safety rating grades (say AA) are merged with moderate safety categories, burdening the lenders with huge risk weights that erode their capital adequacy.
(ii) (iii) (iv)
90. To address the above drawbacks, Bangladesh Bank revised its mapping scale through BRPD Circular No. 35 dated 29 December 2010 (Table 7). Table 7: Revised Mapping of Bangladesh Banks Rating Grade with Rating Scales
Risk Weights for Long-Term Rating Category Equivalent Equivalent Equivalent Equivalent Notch/ Notch/ Notch/ Notch/ Notation of Notation of Notation of Notation of CRISL CRAB NCRL ECRL AAA AAA AAA AAA AA+, AA, AAAA1, AA2, AA3 AA+, AA, AA AA+, AA, AA A+, A, A A1, A2, A3 A+, A, A A+, A, A BBB+, BBB, BBB+, BBB, BBB+, BBB, BBB1, BBB2, BBB BBB BBB BBB3 BB+, BB, BB BB1, BB2, BB3 BB+, BB, BB BB+, BB, BB B+, B, B B+, B, B B+, B, B B1, B2, B3 CCC+, CCC, CCC1, CCC2, CCC3 CCC CC CC+, CC, CC C+, C, C, D C, D C+, C, C, D C, D Risk Weights for Short-Term Rating Category ST-1 ST-1 N1 ECRL-1 ST-2 ST-2 N2 ECRL-2 ST-3 ST-3 N3 ECRL-3 ST-4 ST-4 N4 ECRL-4 ST-5, ST-6 ST-5, ST-6 N5 D Equivalent Notch/ Notation of ACRSL AAA AA+, AA, AA A+, A, A BBB+, BBB, BBB BB+, BB, BB B+, B, B CC+, CC, CC C+, C, C, D ST-1 ST-2 ST-3 ST-4 ST-5, ST-6 Equivalent Notch/ Notation of ACRL AAA AA+, AA, AA A+, A, A BBB+, BBB, BBB BB+, BB, BB B+, B, B, CCC
Bangladesh Banks Rating Grade 1
Risk Weight (%) 20
2 3 4 5
50 a 100/50 100 150/100

b
CC+, CC, CC, C+, C, C, D AR-1 AR-2 AR-3 AR-4 AR-5, AR-6
S1 S2 S3 S4 S5, S6
20 50 50 100 150
ACRL = Alpha Credit Rating, ACRSL = ARGUS Credit Rating Services, CRAB = Credit Rating Agency of Bangladesh, CRISL = Credit Rating Information and Services, ECRL = Emerging Credit Rating, NCRL = National Credit Ratings. Notes: a 50% for banks and 100% for corporates. b 100% for banks and 150% for corporates; 125% for unrated corporates.
19
91. The key changes in revised mapping (29 December 2010) over the initial mapping (29 April 2009) are as follows: (i) (ii) (iii) (iv) AAA and AA rating bands are placed in the Bangladesh Bank Grade 1 bucket which will attract same risk weight, i.e., 20%. Previously AA was partially categorized in the 50% risk weight bucket. A rating band is categorized Bangladesh Bank Grade 2 which will now attract 50% risk weight instead of 100% which was the case earlier. BBB rating band has been upgraded to Bangladesh Bank Grade 3 but risk weight remains 100% for corporate firms. BB rating band has been upgraded to Bangladesh Bank Grade 4 from Grade 5, therefore the risk weight for a BB rating has changed to 100% from 150%. This is a major change.
92. As a consequence of the above changes, many banks were motivated to take initiative to rate their clients. As of October 2012, around 4,500 clients have been brought under the purview of ratings. 93. In Table 8, numbers of ratings and rating history of six rating agencies as of December 2012 are depicted: Table 8: Number of Ratings by Rating Agency
Number of Ratings in 2012a No. of Ratings % 1,314 63 310 293 160 n.a. n.a. 2,077 15 14 8 n.a. n.a. 100 Number of Rating since Inception to December 2012b No. of Ratings % 2,680 48 1,988 396 493 n.a. n.a. 5,557 36 7 9 n.a. n.a. 100
S. no. 1 2 3 4 5 6
Rating Agency (Year of Inception) CRAB (2004) CRISL (2002) ECRL (2011) NCRL(2011) ACRSL (2011) ACRL (2012) Total
Up to 31 December 2012 14 November 2012 5 November 2012 30 September 2012
n.a. = data not available, ACRL = Alpha Credit Rating, ACRSL = ARGUS Credit Rating Services, CRAB = Credit Rating Agency of Bangladesh, CRISL = Credit Rating Information and Services, ECRL Emerging Credit Rating, NCRL = National Credit Ratings. a The ratings conducted only in 2012 by the respective rating agencies and their shares in percentages are shown. b The ratings conducted by the respective rating agencies since their inception (cumulative) and their shares in percentages are shown.
20
94. In Tables 9, 10, and 11, long-term ratings assigned only in 2012 by the respective rating agencies are presented: Table 9: Distribution of Ratings in 2012 by Long-Term Rating Notch
Long-Term Rating Notch AAA AA A BBB BB B CCCD Total CRAB 3 87 151 325 260 31 2 859 CRISL 4 20 98 164 11 2 0 299 NCRL 0 4 69 56 8 0 0 137 ECRL 3 10 33 199 27 1 0 273
CRAB = Credit Rating Agency of Bangladesh, CRISL = Credit Rating Information and Services, ECRL Emerging Credit Rating, NCRL = National Credit Ratings.
Table 10: Distribution of Ratings in 2012 in Percentages

Long-Term Rating Notch AAA AA A BBB BB B CCCD Total CRAB (%) 0.35 10.13 17.58 37.83 30.27 3.61 0.23 100.00 CRISL (%) 1.34 6.69 32.78 54.85 3.68 0.67 0.00 100.00 NCRL (%) 0.00 2.92 50.36 40.88 5.84 0.00 0.00 100.00 ECRL (%) 1.10 3.66 12.09 72.89 9.89 0.37 0.00 100.00
CRAB = Credit Rating Agency of Bangladesh, CRISL = Credit Rating Information and Services, ECRL = Emerging Credit Rating, NCRL = National Credit Ratings.
Table 11: Distribution of Ratings in 2012 by Investment Grade Category

Category Investment Grade (From AAA to BBB) Non-Investment Grade (From BB to D) Total CRAB (%) 65.89 34.11 100.00 CRISL (%) 95.65 4.35 100.00 NCRL (%) 94.16 5.84 100.00 ECRL (%) 89.74 10.26 100.00
CRAB = Credit Rating Agency of Bangladesh, CRISL = Credit Rating Information and Services, ECRL = Emerging Credit Rating, NCRL = National Credit Ratings.
95. A report published by CRAB indicates a median CAR figure in the fiscal year 2011 was 11.40%, which is higher than its temporal requirement of 8% and its permanent requirement of 10%.22 In the fiscal year 2012, CAR was 10.05%, compared with 12.5% in the fiscal year 2009. The figure in 2009 was moderately high as Basel II was introduced in Bangladesh in
22
CRAB. 2012. The Bangladesh Banking Industry Performance Review of Private Commercial BanksFY2011. Dhaka: Credit Rating Agency of Bangladesh.
21
20092010 and it ran parallel with Basel I. Due to new guidelines released in 2010, the overall capital adequacy level dropped; however, that year the banks managed to maintain their CAR fully under the Basel II framework. VIII. INTERNAL CREDIT RATINGS BY COMMERCIAL BANKS IN BANGLADESH
96. As of 31 December 2012, there were 47 commercial banks functioning in Bangladesh. In 2013, eight more banksNon-resident Bangladeshi (NRB) Commercial Bank, NRB Bank, Union Bank (Islami Shariah-based bank), South Bangla Agricultural Bank and Meghna Bank, Midland Bank, Farmers Bank, and NRB Global Bankreceived licenses from the central bank bringing the total number of scheduled banks to 55 (Table 12). Table 12: Banking Sector in Bangladesh
Nature of Banks State-owned commercial banks (SCBs) Private commercial banks (PCBs) Islami Shariah-based PCBs Foreign commercial banks (FCBs) Specialized banks (SBs) Total
Source: Bangladesh Bank.
No. of Banks 4 30 8 9 4 55
97. In the past, commercial banks in Bangladesh used to, by and large, lend to clients who had an established history of reliability and perceived credibility without any systematic objective evaluation of their credit standing. Bangladesh Bank introduced lending risk analysis (LRA) in 1993 as part of banking sector reform, which was replaced by the more comprehensive Credit Risk Grading Model (CRGM) in 2005. In this context, Bangladesh Bank circulated a format for assigning weights to financial risk, management risk, industry risk, business risk, and banking relationship risk. In practice, however, it has been observed that CRGM is not followed properly. Banks still work with principles of targeted lending where the traditional methods of face-lending take precedence over CRG, which is relegated to the status of a formality that must be completed in order to fill the forms. 98. Furthermore, with the exception of a few high investment grade foreign banks, none of the other banking institutions appear to have the capability to undertake internal credit rating. While Bangladesh Bank had been pushing for the adoption of IRBA by 2012, this was not realistic. Even in cases where banks are capital surplus, they are more likely to utilize the capital cushion to invite profitable clients to borrow (even at reduced interest rates) than to incur the large costs of implementing IRBA. 99. One of the preconditions to implementing IRBA is a robust IT platform, required to maintain the customer database for at least 5 years. First, banks in Bangladesh, in general, do not have such sophisticated IT systems. While some have installed IT systems in the recent past, these are yet to be aligned with IRBA compliance needs. Second, there is a serious scarcity of trained personnel who are not only IT-skilled but also have a thorough understanding of the ramifications of maintaining an IT superstructure to serve IRBA requirements. So IT training needs to be backed up by strong banking knowledge, which is a combination tough to
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come by. It will take time for the banks to train and develop staff that can understand the rating system, the customer database, and data updates and analysis for IRBA. Hence, it will be a while before the banking system of Bangladesh is able to migrate to IRBA fully. IX. PROSPECTS FOR CREDIT RATING IN BANGLADESH WITHIN A BASEL II REGIME
100. The understanding of the concept of credit rating has been improving over time in Bangladesh. By formulating CRC Rules 1996, SECB has been trying to usher maturity into the capital market through credit risk rating. By making credit rating mandatory for all equity offerings, SECB demonstrated its serious intent to make credit rating a sustainable proposition in the capital and financial markets of Bangladesh. Other initiatives taken by SECB and Bangladesh Bank in the context of credit rating are enumerated below: (i) Initially, rating was a one-shot opinion of the ECAI regarding the creditworthiness of the rated entity without any subsequent surveillance. SECB, through a major amendment in 2009, introduced surveillance of credit rating. In addition, in order to stop rating shopping, it mandated that the issuer would enter into an agreement with rating agencies for a minimum of 3 years and the surveillance of bonds would continue throughout the life of the instrument. SECB also created an ethical code for rating agencies in line with the IOSCO Code of Conduct. Since Bangladesh is a member of the IOSCO, SECB has to ensure that international regulations are followed by rating agencies in the country. Bangladesh Bank has introduced the Basel II Capital Adequacy Framework for all banking institutions. The standardized approach within Basel II mandates that capital adequacy of banking institutions be calculated by attributing risk weights to their assets based on credit rating of these claims by ECAIs. As a further step, the central bank has recognized seven rating agencies as ECAIs and circulated the format for mapping of the ECAI ratings against the Bangladesh Bank risk grading scale. Unrated clients attract a high risk weight of 125%, indicating that the regulatory authorities are extremely serious about getting all loans rated.
(ii) (iii)
(iv)
101. Clearly, the prospects for DCRAs are bright in Bangladesh as there is active policy and regulatory support and incentive encouraging the rating process both for borrowing as well as lending institutions. However, ensuring quality rating in a highly competitive environment is a challenge. As discussed earlier, the SECB has been issuing licenses to DCRAs without factoring in the market need, size, and basis for pricing. Bangladesh Bank has also been recognizing the newly formed rating agencies as ECAIs without undertaking any costbenefit analysis of the increased competition, thus posing a threat to the rating industry in the country. In Bangladesh, DCRAs follow an issuer-pays business model. In a situation where a corporate firm in Bangladesh can get its accounts audited for Tk5,000 to Tk15,000 (about $61 to $183), incurring an expense of Tk100,000 to Tk300,000 just to get a rating makes little business sense.23
23
$1 is equivalent to Tk81.20 as of 16 April 2012.
23
X.
BANGLADESH BANKS MOVE TOWARD RATING SMALL AND MEDIUM-SIZED ENTERPRISES
102. To enable the development of small and medium-sized enterprises (SMEs) in the country and encourage greater transparency and credit discipline, Bangladesh Bank proposes to launch SME ratings in Bangladesh. SMEs have several unique characteristics that warrant a customized credit assessment framework and methodology as well as separate rating scale and symbol. Unlike the corporate, the SME sector has no organized information on industries, market shares, competition dynamics, and promoter or management track records. The creditworthiness of SME units, therefore, needs to be assessed using tools and methods that are different from those traditionally used for corporate firms. 103. Bangladesh Bank is at the final stage of introducing a common methodology for recognized DCRAs to evaluate SMEs under its proposed rule on Capital Adequacy Policy for SMEs under Basel II Principles. Bangladesh Bank formed an internal working group on ECAI recognition in order to set eligibility criteria for ECAIs (i) (ii) (iii) (iv) to be qualified to rate SMEs; to develop a standard SME rating methodology to be followed by ECAIs (minimum risk factors to be assessed for SME credit rating); to develop a scoring system, a set of notches and symbols that are appropriate for SMEs (distinct from those for corporate firms), and the mapping of these scores against the rating grades of Bangladesh Bank; and to devise appropriate risk weight for each rating category.
104. An elaborate description of credit rating system development for SMEs in Bangladesh is laid down in Appendix 2 of this report. 105. Industrial Policy 2010 and accordingly Circular No. 1 dated 19 June 2011 of the Small and Medium Enterprises Special Programs Department (SMESPD) of Bangladesh Bank defines SMEs in terms of the value of fixed assets with replacement cost excluding land and building or in terms of the number of persons employed (Table 13). Table 13: Categorization of Small and Medium-sized Enterprises in Bangladesh
Category Medium Small Industry Type Manufacturing Service/Trading Manufacturing Service/Trading Value of Fixed Assets (Tk million) 100300 10150 5100 0.510 Number of Persons Employed 100250 1025 2599 1025
106. Bangladesh Banks draft document on SME rating methodology stipulates in the paragraph entitled Objectives of SME Rating that banks and financial institutions are migrating from an opinion-based credit review process of an individual towards a systematic and scientific process with an emphasis on objective inputs. The need for faster, more accurate, uniform, and timely credit decisions is cited as main reason for this shift. The deployment
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of highly productive and easy-to-use tools in decision-making could be an effective solution. The objectives of SME ratings are (i) (ii) (iii) (iv) XI. compliance with standardized approach of Basel II requirements; creation of risk rating system; help to automate credit origination, credit approval process, risk administration, and monitoring functions and management of non-performing assets; and help to provide data feeds for management reporting. CONCLUSIONS
107. Credit rating is comparatively new in Bangladesh although SECB framed the regulations for it way back in 1996. The banking and business community in Bangladesh is gradually getting familiar with the concept as Basel II is being unrolled. Bankers are showing keenness to migrate from CRGM into making investments based on counterparty rating, a development that can improve the prospects of the rating industry by compelling it to act responsibly and conduct its business ethically. Even counterparties are depending more and more on rating reports to identify operational drawbacks or lacunae that would have hitherto been overlooked due to lack of awareness. 108. A phenomenal change in private sector financing in Bangladesh can therefore be expected as regulatory directives gradually increase the volume of rating activities. Assessment of capital adequacy of banks through the credit ratings of borrowers has heightened the general interest in the credit rating industry. 109. The government has been working on developing debt markets by issuing benchmark treasury bonds with maturities of 5, 10, 15, and 25 years. Besides, the Government of Bangladesh seeks capital markets as an avenue for financing large infrastructure projects and offloading public sector entities. Therefore, the outlook for expanding local debt market and credit rating activities is promising.
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APPENDIX 1: ADB BEST PRACTICE HANDBOOK

Requirement of international best practice suggested by ADB handbook I. ESSENTIAL BEST PRACTICES Pre-Rating Requirements Written contract between DCRA and ratee DCRA cannot promise, assure, or guarantee a particular rating outcome Rating definitions, policy for use, and rating criteria are to be explained to the rating entity before rating services are engaged Publication of policies and processes Availability of adequate resources personnel with skills facilities such as software for information processing and regular training, and adequate financial resources for business development, outreach activities, and surveillance process with minimum capital suggested $3 million$5 million Revision in organizational structure and rating process Rating Definitions and Recognition of Default Disclosure whether rating indicates probability of default or expected loss Preparation of concrete definition of default Policies and Processes for Rating Consistency in application of rating policies Use of updated criteria and management meetings for ratings assignments Initial rating assignment and appeal process Publication of ratings Surveillance policy Withdrawal policy Formation of functional groups Training plan Preparation of operations manual Policies for dependence on third party Miscellaneous other activities Confidentiality Requirements Confidentiality of ratees information Applicability of confidentiality to all employees No access to those not involved in the rating assignment Contractual arrangement to ensure confidentiality Analytical Independence and Avoidance of Conflicts of Interest Policies to manage conflicts of interest Policies on trading and investment declaration Formulation of other policies to ensure independence and avoidance of conflicts of interest Private, Unaccepted, and Unsolicited Ratings Formulation and adherence to policies General Code of Conduct Adoption of internal code Affirmation of compliance with code The International Organization of Securities Commissions (IOSCO) Code of Conduct Adherence to the code of conduct Process Audit and Compliance Officer Institution of audit process Appointment of Compliance Officer Whistle-blower policy continued next page
1 1.1 1.2 1.3 1.4 1.5
1.6 2 2.1 2.2 3 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 3.11 4 4.1 4.2 4.3 4.4 5 5.1 5.2 5.3 6 6.1 7 7.1 7.2 8 8.1 9 9.1 9.2 9.3
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Continued from previous page 10 10.1 11 11.1 4.1 4.1.1 4.1.2 4.1.3 4.2 Outreach Initiatives Initiation of outreach activities Relation with Regulator and Other Domestic Rating Agencies (DCRAs) Formulation of relevant policies and compliance Computation of Default Statistics Every rating agency should publish, at least annually, a default and transition study, along with the methodology used for calculating default rates. In the methodology employed for calculation of the default rates, the common features designated in the handbook are recommended. Transition rates should ideally be calculated and published on the basis of a 1-year observed transition. Dedicated Advanced Functional Groups Have the following functional groups been formed: (a). Industry focus group (b). Quality assurance group (c). Library and data management group Conflicts of Interest between Other Businesses: Has detailed due diligence been undertaken in areas where co-mingling of diverse DCRA business lines pose conflicts of interest, and in such cases have operational firewalls been put in place and are they fully adhered to? Are Rating Enhancers Used as Early Warning Indicators? Are the Rating Criteria Published? Is Market Feedback Obtained before Major Policy Changes?
4.3
4.4 4.5 4.6
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APPENDIX 2: CREDIT RATING SYSTEM DEVELOPMENT FOR SMALL AND MEDIUM-SIZED ENTERPRISES A. Background
1. Small and medium-sized enterprises (SMEs) are a priority policy area for the Bangladesh government, holding the key to inclusive socioeconomic growth in the country. SMEs are usually born out of entrepreneurial passion, which is generally backed by limited funding. Business systems are often heterogeneous and independent. Moreover, tangible and intangible business assets of SMEs are rudimentarily defined, and the value of such assets is often only partially known. Typically this is the case with one of the most important assets, namely, information. 2. SMEs face a plethora of challenges in terms of lack of access to information, lack of adequate finance, technological disadvantages, and backdated marketing and managerial skills. 3. Bangladesh Bank has reported that SME lending grew 17.02% in AprilJune 2012 over AprilJune 2011 while having achieved only 24.20% of the sector target, indicating the immense potential that is locked in this space. 4. The segment is still immature and does not display standard patterns. The success of the SME development strategy outlined by Bangladesh Bank also depends on an individual banks strategic interest in the SME business, which includes many factors: (i) (ii) (iii) (iv) (v) demand for credit; competition among the banks in different segments; corporate strategy of banks, i.e., are they corporate-focused or SME-focused?; macroeconomic, regulatory, and institutional factors; and business model and risk management processes used by the bank when dealing with SMEs, which answers the following questions: How is financing promoted? How is cost minimized? How is credit risk managed and how are risks controlled? Inadequate FundingA Key Constraint to Growth of Small and Medium-sized Enterprises
B.
5. Access to finance has been extensively studied in Bangladesh, identified as a major barrier to growth of small enterprises. Whenever the credit is available, the rate of interest is high and at par with that for large enterprises. These barriers are of many kinds and in lowering them lies the key to unlocking SME growth. 6. Lack of access to finance. Institutional limitations, such as an underdeveloped and inefficient legal and regulatory framework, pose significant barriers to effective financing. Banks face a number of issues in lending to SMEs, the most pronounced being information asymmetry and granularitythe level of detail available on which to base business decisions. Banks do not have the requisite information and systems in place to quantify risk and differentiate between SMEs. This has resulted in tightened credit terms and inefficient allocation of resources. Another factor is the issue of moral hazard, wherein SMEs are perceived to take higher risks than larger companies with funds borrowed from banks. Therefore, a mechanism should be
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developed under which SMEs are mandated to provide accurate, reliable, and quality information so that lenders can carry out precise risk assessment. 7. High cost of finance. The high cost of finance is a common problem for SMEs and loan repayment terms are not borrower-friendly. This can be attributed to two factors: first, a mismatch between repayment cycles and cash flow cycles of different businesses (which will not be the same for say, poultry producers, cold storage companies, crop farmers, packing units, and foundries); and second, lack of flexibility in repayment terms (say, through rescheduling of debt) and rigid liquidation procedures. 8. Large collateral requirements. Banks are also known to demand large amounts of from SMEs because lending systems are based more on borrowing backed by assets than project earnings and cash flow. Many banks have revealed that they insist on large amounts of collateral as a safeguard against losses from risk exposure. 9. Collateral-based lending can prove a major barrier because of the difficulties faced in assessing the quality of land offered and in obtaining an unblemished ownership title and deed. On many occasions, banks also do not accept the same kind of collateral from SMEs (such as sales or project contracts) that they would from large borrowers. Another problem with SME lending is the mismatch between the loan size and the value of collateral as, in most cases; the value of the collateral is typically greater than the loan sought. The forced sale of an asset to repay a smaller amount than it is worth imposes an unfair constraint on the borrower. 10. Credit information gap. The absence of or limited track record of DCRAs with regard to SME ratings, low analyst coverage of SMEs, and lack of access to information are some of the barriers to credit appraisal of SMEs. The ability of banks to develop exhaustive credit models for the SME segment is impaired by lack of data. Greater availability, centralization, and documentation of such data would not only promote better access to finance, but also aid in developing a more thorough understanding of the risk profile of the sector. 11. At present, riskiness of lending to a large enterprise is assessed either on the basis of the lenders own risk management policy and the Credit Risk Grading Manual (CRGM) of Bangladesh Bank or through the Basel II framework, where capital adequacy of the lender is linked with ratings of the banks counterparty by an external credit assessment institution (ECAI).1 Even in the case of SMEs, unfortunately, most lenders (apart from a few SME-focused
Bangladesh Bank back in 2004 decided that an integrated CRGM would be developed with a view to render a need-based simplified and user-friendly model for application by the banks and financial institutions in processing credit decisions and evaluating the magnitude of risk involved therein. Subsequently, through BRPD Circular No. 18 dated 11 December 2005, all scheduled banks were advised to implement Credit Risk Grading Manual for all exposures (irrespective of amount) other than those covered under consumer financing and short-term agricultural and micro credit. Credit risk grading was now mandatory for all lending exposures undertaken by a bank irrespective of fresh approvals or renewal cases. The risk grading matrix provided in the manual set the minimum standard of internal risk rating and banks were allowed to adopt and adapt more sophisticated risk grades in line with the size and complexity of their business. It was highlighted in the manual that the CRG outputs would be relevant for deciding on individual credit selection, pricing (credit spread), and specific features of the credit facility. (It is largely constituted of obligor-level analysis.) Risk grading is also relevant for surveillance and monitoring, internal MIS, portfolio analysis, and assessment of the aggregate risk profile of a bank. The CRG scale consists of eight categories: Superior, Good, Acceptable, Marginal/Watch list, Special Mention, Substandard, Doubtful, and Bad and Loss. Credit risk for the counterparty arises from an aggregation of the following risks: financial risk, business/industry risk, management risk, security risk and relationship risk. Each of the above-mentioned key risk areas is evaluated and aggregated to arrive at an overall risk grading measure.
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banks such as BRAC Bank, Standard Chartered Bank, Islami Bank, and Eastern Bank, which follow their own credit risk models customized to SMEs) use the same risk management framework as that for corporate firms and large enterprises to arrive at a lending decision. Under the Basel II framework, for calculating capital adequacy of banks, the SME segment does not necessarily require external credit rating. Therefore, banks in general follow the CRG system of Bangladesh Bank to assess SMEs. 12. The CRG system of Bangladesh Bank is limited by the fact that it does not differentiate between SME risk and corporate risk. The risk grading matrix provided in the manual only sets a baseline, minimum standard for internal risk rating. 13. Bangladesh Bank actually gave a broader risk management framework within which a commercial bank, depending on its strategy and risk appetite, could use to adopt an appropriate risk management metric that could be customized to a mix of borrowers across SME, corporate, and retail segments. 14. However, because of high risk and high transaction cost perceived in lending to SMEs and in the absence of appropriate credit risk management and monitoring tools, most banks are reluctant to take a large stake in SME lending. 15. Therefore, irrespective of whether the potential borrower is an SME or a corporate firm, banks rely more on collateral, which is a serious obstacle for SMEs. 16. Cumbersome documentation process. Borrowers face difficulties in comprehending documentation processes stipulated by lenders, many of which have been found to be numerous and complex. 17. Limited spread and reach of banks. The limited network of banks in smaller towns and rural areas restricts borrowers access to credit. Although the banking sector is the most important source of external financing for SMEs, they underserve the needs of the sector. Many SMEs are forced to rely on retained earnings and informal avenues for borrowing that can take considerable time to accumulate. Shortage of finance could well be the primary impairment to the competitiveness and growth of SMEs in Bangladesh. C. How Recognized Domestic Credit Rating Agencies Can Contribute to Credit Rating and Development of Small and Medium-sized Enterprises
18. Modern credit risk appraisal through DCRAs recognized by Bangladesh Bank brings significant advantages for SMEs. 19. Appropriate evaluation and risk assessment through a credit rating approach customized to SMEs as opposed to a conventional approach can make it easier for them to borrow. Creating a rating system for SMEs is not easy as it is not merely about tweaking a process meant for assessing large companies. Producing a new framework for rating SMEs is important, because most enterprises would otherwise receive low ratings on traditional scales solely because of their small size. The benchmarks used for large corporations have to be abandoned. One of the common misconceptions about SMEs is that they are unwilling to incur the cost of being rated. As more SMEs that decide to be rated find that this eases their access to bank loans and reduced interest rates, the proclivity in the segment to undergo the credit rating process will also rise.
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20. Bank lending to SMEs can expand only if the existing credit risk management framework is augmented and appropriate tools and techniques are devised and applied to assessing riskiness of SMEs. 21. This paper proposes a rating scale of SME1 to SME8 that can be used to rate SMEs using the data of other SMEs as peer and benchmark such that there is a better spread across sectors and profiles of different units can be compared. 22. The proposed SME rating scale is presented in Table A2.1. Table A2.1: Proposed Rating Scale for Assessing Credit-Quality Ratings Assigned by a Domestic Credit Rating Agency to a Small or Medium-sized Enterprise
Rating Notches SME 1 SME 2 SME 3 SME 4 SME 5 SME 6 SME 7 SME 8
SME = small and medium-sized enterprise.
Rating Definition Highest quality High quality Adequate Moderate Inadequate Risk-prone Poor Poorest
23. Table A2.2 presents an SME scoring system and a framework comprising key analytical determinants of rating, sub-factors, and their weights. 24. It is noted that ratings are forward looking and incorporate expectations of future financial and operational performance. The rating process makes use of both historical and projected financial results. Historical results of operations help the analyst understand performance patterns and draw peer comparisons. Historical data helps the analyst to look through the earnings volatility associated with the business cycle and evaluate whether projected future results are realistic. The rating process makes use of both historical and projected financial results. It is also possible that in specific SMEs any one parameter may override other parameters to such a large extent that it may become a rating driver. D. Mapping Rating Factors to Rating Categories
25. On the rating scale of SME1 to SME8, value ranges (in minimummaximum pairs) for each sub-factor may be set based on the DCRAs expectations for each rating category. With the ranges identified, the DCRA may map the outcomes for each sub-factor to a rating category: (i) (ii) For quantitative sub-factors, such as those related to earnings or profitability, the DCRA could place a firms actual EBITDA margin against the SME1 to SME8 scale for EBIDTA to see where it fits. For the qualitative sub-factors, the DCRA could assign sub-factor rankings either for all the firms relative to one another or based on absolute criteria including both quantitative and qualitative parameters. As with quantitative sub-factors, DCRA could use the SME1 to SME8 scale.
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Table A2.2: Rating Factors and Sub-Factors and Their Weights

Rating Factors 1. Operational and Business Risk Premises, Product and Services, People Element, Purchasing, Protection, Procedures, Performance, Planning, Policy, and Processes 2. Environmental Risk 3. Financial Risk Earnings and Stability Sales EBITDA Trends Profitability EBITDA Margin ROA Liquidity Liquidity Index Current/Quick Ratio Working Capital Management OI/NWC Sales to Working Capital Limit Average Inventory Period Average Collection Period Average Payment Period Leverage and Net Worth Debt/EBITDA D/(D+E) Coverage EBIT/Interest DSCR 4. Management Risk Promoters Track Record and Qualification Management Quality and Succession Planning Administrative Setup and Delegation Culture Weight (%) 40.00
5.00 35.00 5.25
5.25
3.50
7.00
7.00
7.00
20.00 8.00 6.00 6.00
DSCR = debt service coverage ratio; EBITDA = earnings before interest, tax, depreciation and amortization; OI/NWC = operating income/net working capital; ROA = return on asset. Notes: i. Each rating factor (Factor 1 to Factor 4) is given a weight based on the importance of that particular factor in the rating. The sum of factors weighted should equal to 100. The weights assigned to various parameters may vary from SME to SME depending on the specifications of the said enterprise. ii. Based on the risk analysis, each sub-parameter is assigned an appropriate rating score. iii. The weighted rating score for each rating sub-parameter is then computed by multiplying its weight with its rating score. iv. The total weighted rating score is then arrived at by calculating the sum of the sub-parametric weighted rating scores and rounding it off to the nearest integer. v. Using the DCRAs Look-up Table, the rating equivalent to the total weighted rating score is arrived at. vi. This rating can be deemed to be the model implied rating. vii. Model implied rating may be adjusted with sector-specific issues and deemed to be the final rating.
26. Once the broad rating category has been determined for each sub-factor, it could be converted into a numerical equivalent, as per the conversion table presented in Table A2.3:
Table A2.3: Conversion of Factor Ratings into Numeric Values

Rating Categories Notches SME1 1 SME2 2 SME3 3 SME4 4 SME5 5 SME6 6 SME7 7 SME8 8
SME = small and medium-sized enterprise.
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27. The eight rating categories span the full rating spectrum from SME1 to SME8. Each specific rating is mapped to a numeric equivalent, using a simple linear scale (e.g., SME1 = 1, SME8 = 8). Upon converting each sub-factors rating category into a number, it can be multiplied by the sub-factors scorecard weight, providing a weighted average of all the sub-factor ratings. E. Deriving Ratings through the Scorecard
28. Table A2.4 depicts an illustrative scorecard for SME ratings. Corresponding to the rating factor in the left most column the actual position of the SME being rated is provided in the Input column. From the conversion table, input description and numbers are mapped and a raw score is calculated. In the last column, the raw score is multiplied with the corresponding weight and finally model implied rating score is derived. Table A2.4: Rating Scorecard for a Small or Medium-sized Enterprise (for illustration only)
Raw Score from Conversion Table (a) 4 Weight in % (b) 40.00 Weightage Score (c = a x b) 1.60
Rating Factors 1. Operational and Business Risk Premises, Product and Services, People Element, Purchasing, Protection, Procedures, Performance, Planning, Policy, and Processes 2. Environmental Risk 3. Financial Risk Earnings and Stability Sales EBITDA Trends Profitability EBITDA Margin ROA Liquidity Liquidity Index Current/Quick Ratio Working Capital Management OI/NWC Sales to Working Capital Limit Average Inventory Period Average Collection Period Average Payment Period Leverage and Net Worth Debt/EBITDA D/(D+E) Coverage EBIT/Interest DSCR 4. Management Risk Promoters Track Record and Qualification Management Quality and Succession Planning Administrative Setup and Delegation Culture Model Implied Score Mode Implied Ratings
Input Moderate
Low
5.00 35.00 2.63 2.63 2.63 2.63 2.00 1.50 2.00 2.00 1.00 1.00 1.00 3.50 3.50 3.50 3.50 20.00 8.00 6.00 6.00
0.10
Tk500 million Increasing 24.3% 4.5% 270 1.45 24.0% 1.45 90 120 30 0.45 0.65 2.5 1.9 Good Moderate Weak
3 2 1 1 2 3 3 5 4 5 2 2 2 3 3 3 4 6
0.08 0.05 0.03 0.03 0.04 0.05 0.06 0.10 0.04 0.05 0.02 0.07 0.07 0.11 0.11 0.24 0.24 0.36 3.43 SME3
D = debt; DSCR = debt service coverage ratio; E = equity; EBIT = earnings before interest and taxes; EBITDA = earnings before interest, tax, depreciation and amortization; OI/NWC = operating income/net working capital; ROA = return on assets.
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29. The model implied score of 3.43, which was derived by using the above scorecard, is then mapped to one of the eight ratings using the factor numeric table (Table A2.5), producing the final scorecard derived rating (model implied rating) of the SME, which is SME3. Table A2.5: Factor Numeric Table of Small and Medium-sized Enterprises; 8-Notch Rating Scale (for illustration only)
>= 1.00 1.50 2.50 3.50 4.50 5.50 6.50 7.50 <= 1.49 2.49 3.49 4.49 5.49 6.49 7.49 8.00 Ratings SME-1 SME-2 SME-3 SME-4 SME-5 SME-6 SME-7 SME-8
30. The ratings on SMEs reflect the overall creditworthiness of the rated units, adjudged in relation to other SMEs. These ratings are unit-specific, and not related to bank loans or debt issuances. 31. The objectives of assessing SMEs and corporate rating are not identical. Credit rating of SMEs does more than provide credit information. It creates greater awareness among SME entrepreneurs and managers and builds their knowledge and capabilities in identifying business lacunae and addressing them. In addition to easing access to finance for SMEs, credit rating can, in the medium to long term, be expected to lead to sector growth and inclusive development of the economy. 32. (i) (ii) Advantages of undertaking SME ratings for various stakeholders are as follows: For individual SMEs. Create awareness about credibility and creditworthiness of SMEs leading to credit discipline and transparency. For commercial banks. Increase awareness among commercial banks about automated credit origination, data processing, approval, risk administration, minimization of credit assessment cost, and timely risk status reporting to management with their banking business. Enable migration from an individuals opinion-based credit review process toward a systematic and scientific process with emphasis on objective inputs. Ensure a shift towards faster and more accurate, uniform, and timely credit decisions, wherein risk is properly managed For DCRAs. With the development of an overall rating culture among SMEs as well as commercial banks, DCRAs will have the incentive to cater to this segment through objective, independent, transparent, and credible methodology. For policy makers. An appropriate rating report allows an SME to compare its performance at a local, regional, and even global scale while establishing its overall position within the sector. Ratings of SMEs taken together can facilitate better and more targeted policy making that can give refined focus to the segment instead of a one-size-fits-all approach.
(iii) (iv)
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(v)
For the SME segment. Overall, SME financing opportunities will expand, investment quality in SMEs will improve, and competitive market for SME ratings will emerge in Bangladesh. Proposal for a Rating Fund for Small and Medium-sized Enterprises
F.
33. Multilateral financial institutions and other donor agencies could set up an SME rating fund (minimum $0.5 million) to facilitate bank lending to SMEs (Figure A2). Rating agencies with SME rating systems in place could be assigned by the fund to (i) (ii) (iii) 34. (i) (ii) (iii) review best practices in SME rating, determine standard methodology and scale for rating SMEs, and develop selection criteria for prospective rating firms in collaboration with Bangladesh Bank and commercial banks in Bangladesh. The fund could also identify and select SMEs for rating based on predetermined criteria, which could be developed in greater detail with Bangladesh Bank; test the rating systems and revise and update it based on the results, and provide financial assistance for SME credit rating based on approved SME customized methodology to DCRAs.
35. Bangladesh Banks SMESPD could act as an implementing agency and counterparty to the fund. Bangladesh Bank could requisition from each commercial bank, a list of SMEs that are interested in coming under the rating purview, and from this list select SMEs to be rated based on a set of predetermined criteria. A few hypothetical criteria are listed below: (i) (ii) (iii) (iv) Select at least 10 SMEs from the list of prospective SME borrowers of each bank. Do not select more than 10% SMEs from a single geography. Do not select more than 10% SMEs from a single trade. Ensure that no category of SMEs (across small manufacturing, medium manufacturing, small services, and medium services) has a share of less than 20% in the total SMEs to be rated.
36. To encourage enterprises to obtain the ratings, the fund could make an inaugural offer of, say, a 100% subsidy on the first rating exercise of an SME (rating valid for 12 months) through a multilateral financial institution routed to Bangladesh Bank (SMESPD). Subsequent ratings could be paid for in full by the SME.
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Figure A2: Credit Rating Scheme in Bangladesh for Small and Medium-sized Enterprises
Aid Agency Grant or Concession Government Bangladesh Bank Subsidy for DCRA fees Wings of Bangladesh Bank Accreditation for DCRAs
SMESPD
BRPD
Provides accreditation to DCRA for SME rating
Banks provide list of potential SME clients for credit rating based on selection criteria Commercial banks in Bangladesh
CR Report
CR Fee CR Report
Accredited Credit Rating Agencies
Banks identify potential SMEs for credit rating
Provides information
CR Report
SMEs
BRPD = Banking Regulation and Policy Department, CR = credit rating, DCRA = domestic credit rating agency, SME = small and medium-sized enterprise, SMESPD = Small and Medium Enterprises and Special Programmes Department.
G.
How Would the Rating Fund for Small and Medium-sized Enterprises Bring Benefits for the Segment?
37. The fund could provide both finance as well as technical support in order to lower the access barriers for SMEs and standardize credit rating for them. (i) Integrated approach toward SME finance. These interventions can help reduce the probability and impact of defaults and minimize overall transaction costs to investors and lenders. Defaults are linked to information asymmetries, which can be
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(ii)
(iii)
(iv) (v)
(vi)
reduced. Through this initiative, if the SME rating enjoys wide acceptability, most banks would then treat it as part of their internal credit evaluation process and be ready to offer interest rate incentives to SME borrowers. The concept of external ratings would help SMEs achieve an independent identity, access funds, attract foreign investors, and develop growth strategies. Improved cost-efficiency for SME financing. Currently, each bank uses its own risk management unit to evaluate an SME. Hence, an SME going to multiple lenders is evaluated repeatedly, which is needless duplication of effort and cost. Third-party SME rating can completely eliminate this problem. Overcome interest rate-related constraints. Since banks believe that SMEs are high-risk investments, they are charged interest rates that are 5%6% higher than that extended to corporate firms. With credible SME ratings by DCRAs, Bangladesh Bank will be in a position to issue separate directives on capital adequacy policy on SME-lending under Basel II principles. This will lead to immediate capital relief for banks and could translate to a 0.5%1.5% reduction in interest rates charged to SME borrowers. Overcome large collateral requirements. Good rating may be a substitute for high collateral. Mitigate constraints of limited spread and reach of banks. The limited network of banks in smaller towns and rural areas restricts borrowers access to credit. Through external credit assessment, banks could extend their outreach without increasing their network. Research impact of SMEs on other drivers of economic development. Lack of systematic information is one of the reasons why empirical research on SMEs has been limited and little empirical evidence links access to finance to development outcomes. Many stakeholders want to understand the impact of SME growth on cluster formation, formalization, or gender and economic inequality. Systematic information provided by this intervention will encourage the empirical research.
Regulatory Framework and Role of Domestic Credit Rating Agencies in Bangladesh Recently, the rating assessment by Domestic Credit Agencies (DCRAs) in Bangladesh has become crucial in calculating the capital adequacy for commercial banks. The use of credit rating is to lead to establishing acceptable measures of credit risk evaluation for commercial banks to meet BaselII regulatory prescriptions. Furthermore, Bangladesh Bank plans to introduce ratings for small and medium-sized enterprises (SMEs) and a customized credit assessment framework for SMEs apart from the usual bank loan ratings. Credit ratings could fill a critical gap in the credit information continuum, moving away from collateral-based lending to risk-based lending forSMEs.
About the Asian Development Bank ADBs vision is an Asia and Pacific region free of poverty. Its mission is to help its developing member countries reduce poverty and improve the quality of life of their people. Despite the regions many successes, it remains home to two-thirds of the worlds poor: 1.7 billion people who live on less than $2 a day, with 828 million struggling on less than $1.25 a day. ADB is committed to reducing poverty through inclusive economic growth, environmentally sustainable growth, and regional integration. Based in Manila, ADB is owned by 67 members, including 48 from the region. Its main instruments for helping its developing member countries are policy dialogue, loans, equity investments, guarantees, grants, and technical assistance.
Asian Development Bank 6 ADB Avenue, Mandaluyong City 1550 Metro Manila, Philippines www.adb.org/poverty Publication Stock No. WPS146204
Printed in the Philippines

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