credit rating of bank financial by- vrushank mehta

8/2/2019 Credit Rating of Bank Financial by- Vrushank Mehta

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Project Report on

Credit Rating Procedure ofBanks/Financial Institutions

Submitted by

Vrushank Mehta

PGDBM Finance, 2005 07

Project Guide

Prof. Mohite

UNIVERSITY OF MUMBAI

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N.L.DALMIA INSTITUTE OF MANAGEMENT STUDIES AND

RESEARCH, MUMBAI

CERTIFICATE

This is to certify that the project entitledCredit Rating procedure of Banks &Financial Institutions is successfullycompleted by Mr. Vrushank Mehta duringPGDBM Semester IV in partial fulfillment ofthe course under University Of Mumbai

through N. L. Dalmia Institute OfManagement Studies & Research.

Prof. P.L.AryaProf. MohiteDirectorProject Guide

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ACKNOWLEDGEMENT

I wish to thank and express my gratitude tothose who extended their valuable co-operation and contribution towards theproject who took out of their busy scheduleand provided easy access to theinformation required.

I would also like to thank my project guideProf. Mohite for timely and unobtrusiveguidance given to me.

Also thanks to my friends and colleagues

for their enduring patience and valuablecriticism which shaped the project well.

Vrushank Mehta

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EXECUTIVE SUMMARYEXECUTIVE SUMMARY

The Reserve Bank of India (RBI), Indias central bank, is responsible for licensing and

supervising financial institutions and banks as well as non-banking financial companies.

Established in 1934, the RBI is vested with extensive powers under The RBI Act, 1934 and

The Banking Regulation Act, 1949 to monitor and regulate all commercial banks and

banking activities in India. The RBI has laid down guidelines on the prudential norms with

which it expects all commercial banks to comply. The areas covered include capital

adequacy, income recognition and asset classification, provisioning for non-performing

assets (NPAs), valuation of investments and other related matters. These guidelines are

based on the November 1991 recommendations of the Committee on the Financial System

(The Narasimham Committee)set up by the RBI and the subsequent 1998 suggestions of

the Committee on Banking Sector Reforms (the second Narasimham Committee). In recent

years, the RBI has been tightening its prudential norms to bring them into line with best

international practice. A basic precept of rating is that one should get to understand the

business of the bank in question, the objectives of its management, the environment it

operates in and the most likely future development of its business. This assists in arriving at

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a rating judgement rooted in an international perspective, which, nevertheless,

accommodates the particular circumstances of the bank (whether national, regional or

sectoral), preventing hasty pre-judgements based on criteria which are in one way or

another inappropriate. There are, however, certain universally applicable attributes of banks

asset quality is a good example - for which the rating agency considers it is possible, and

desirable, to set standards which have a degree of uniformity.

Table of contentTable of content

Topic PageNumber

Introduction 1

Rating Definition 3

Rating Process & Framework 11

Credit Rating Process Of Bank & Financial

Institution

15

Case Report I 32

Case Report II 54

Conclusion 56

Annexure-I 57

Annexure-II 65

Annexure-III 66

Annexure-IV 68

Bibliography 69

IntroductionIntroduction

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The primary objective of rating is to provide guidance to investors\creditors in determining

a credit risk associated with a debt instrument\credit obligation. It does not amount to a

recommendation to buy, hold or sell an instrument as it does not take into consideration

factors such as market prices, personal risks preferences and other considerations which

may influence an investment decision. The rating process is itself based on certain givens.

The agency, for instance, does not perform an audit. Instead, it is required to rely on

information provided by the issuer and collected by analysts from different sources,

including interactions in -person with various entities. Consequently, the agency does not

guarantee the completeness or accuracy of the information on which the rating is based. To

quote "In determining a rating, both quantitative and qualitative analyses are employed.

The judgment is qualitative in nature and the role of the quantitative analysis is to help

make the best possible overall qualitative judgment because, ultimately, a rating is an

opinion." Standard & Poors

Ratings, usually expressed in alphabetical or alphanumeric symbols, are a simple and easily

understood tool enabling the investor to differentiate between debt instruments on the basis

of their underlying credit quality. The credit rating is thus a symbolic indicator of the

current opinion of the relative capability of the issuer to service its debt obligation in a

timely fashion, with specific reference to the instrument being rated. It is focused on

communicating to the investors, the relative ranking of the default loss probability for a

given fixed income investment, in comparison with other rated instruments.

Credit Rating; as elucidated by the leading rating agencies of the world

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"A rating is an opinion on the future ability and legal obligation of the issuer to make

timely payments of principal and interest on a specific fixed income security. The rating

measures the probability that the issuer will default on the security over its life, which

depending on the instrument, may be a matter of days to 30 years or more. In addition, long

term ratings incorporate an assessment of the expected monetary loss should a default

occur." Moodys " Credit ratings help investors by providing an easily recognizable, simple

tool that couples a possibly unknown issuer with an informative and meaningful symbol of

credit quality." Standard & Poors

A rating is specific to a debt instrument and is intended as a grade, an analysis of the credit

risk associated with the particular instrument. It is based upon the relative capability and

willingness of the issuer of the instrument to service the debt obligations (both principal

and interest) as per the terms of the contract. Thus a rating is neither a general purpose

evaluation of the issuer, nor an overall assessment of the credit risk likely to be involved in

all the debts contracted or to be contracted by such entity.

RATING DEFINITIONSRATING DEFINITIONS

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Long Term Rating ScalesHigh Investment Grades

AAA

(Triple A)

Highest

Safety

Debentures rated ÀAA' are judged to offer highest safety of timely payment

of interest and principal. Though the circumstances providing this degree of

safety is likely to change, such changes as can be envisaged are most

unlikely to affect adversely the fundamentally strong position of such

issues.AA

(Double A)

High Safety

Debentures rated 'AA' are judged to offer high safety of timely payment of

interest and principal. They differ in safety from ÀAA' issues only

marginally.

Investment Grades

A

Adequate

Safety

Debentures rated À' are judged to offer adequate safety of timely payment

of interest and principal; however, changes in circumstances can adversely

affect such issues more than those in the higher rated categories.BBB

(Triple B)

Moderate

Safety

Debentures rated `BBB' are judged to offer sufficient safety of timely

payment of interest and principal for the present; however, changing

circumstances are more likely to lead to a weakened capacity to pay interest

and repay principal than for debentures in higher rated categories.

Speculative GradesBB

(Double B)

Inadequate

Safety

Debentures rated `BB' are judged to carry inadequate safety of timely

payment of interest and principal; while they are less susceptible to default

than other speculative grade debentures in the immediate future, the

uncertainties that the issuer faces could lead to inadequate capacity to make

timely interest and principal paymentsB

High Risk

Debentures rated `B' are judged to have greater susceptibility to default;

while currently interest and principal payments are met, adverse business or

economic conditions would lead to lack of ability or willingness to pay

interest or principal.C

Substantial

Risk

Debentures rated `C' are judged to have factors present that make them

vulnerable to default; timely payment of interest and principal is possible

only if favorable circumstances continue.D

In Default

Debentures rated `D' are in default and in arrears of interest or principal

payments or are expected to default on maturity. Such debentures are

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extremely speculative and returns from these debentures may be realized

only on reorganization or liquidation.

Note:

1) CRISIL may apply "+" (plus) or"-" (minus) signs for ratings from AA to

D to reflect comparative standing within the category.

2) The contents within parenthesis are a guide to the pronunciation of the

rating symbols.

3) Preference share rating symbols are identical to debenture rating symbols

except that the letters "pf" are prefixed to the debenture rating symbols, e.g.

pfAAA ("pf Triple A").

Fixed Deposit Rating ScalesFAAA

("F Triple

A") Highest

Safety

This rating indicates that degree of safety regarding timely payment of

interest and principal is very strong.

FAA

("F Double

A") High

Safety

This rating indicates that the degree of safety regarding timely payment of

interest and principal is strong. However, the relative degree of safety is not

as high as for fixed deposits with "FAAA" rating.

FA

Adequate

Safety

This rating indicates inadequate safety of timely payment of interest and

principal. Such issues are less susceptible to default than fixed deposits

rated below this category, but the uncertainties that the issuer faces couldlead to inadequate capacity to make timely interest and principal payments.

FB

Inadequate

Safety

This rating indicates inadequate safety of timely payment of interest and

principal. Such issues are less susceptible to default than fixed deposits

rated below this category, but the uncertainties that the issuer faces could

lead to inadequate capacity to make timely interest and principal payments.FC

High Risk

This rating indicates that the degree of safety regarding timely payment of

interest and principal is doubtful. Such issues have factors at present that

make them vulnerable to default; adverse business or economic conditionswould lead to lack of ability or willingness to pay interest or principal.

FD

Default

This rating indicates that the issue is either in default or is expected to be in

default upon maturity.

Note: 1) The rating agency may apply "+" (plus) or"-" (minus) signs for ratings

from FAA to FC to indicate the relative position within the rating category

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of the company raising fixed deposits.


rating symbols.

Rating For Short-Term Instruments (Commercial Paper)P-1 This rating indicates that the degree of safety regarding timely payment on

the instrument is very strong.P-2 This rating indicates that the degree of safety regarding timely payment on

the instrument is strong; however, the relative degree of safety is lower than

that for instruments rated "P-1".P-3 This rating indicates that the degree of safety regarding timely payment on

the instrument is adequate; however, the instrument is more vulnerable to

the adverse effects of changing circumstances than an instrument rated inthe two higher categories.

P-4 This rating indicates that the degree of safety regarding timely payment on

the instrument is minimal and it is likely to be adversely affected by short-

term adversity or less favorable conditions.P-5 This rating indicates that the instrument is expected to be in default on

maturity or is in default.Note : CRISIL may apply "+" (plus) sign for ratings from P-1 to P-3 to reflect a

comparatively higher standing within the category

Rating Scales For Structured Obligations (so)AAA(so)

(Triple A

SO)

This rating indicates highest degree of certainty regarding timely payment

of financial obligations on the instrument. Any adverse changes in

circumstances are most unlikely to affect the payments on the instrument.AA(so)

(Double A

SO)

This rating indicates high degree of certainty regarding timely payment of

financial obligations on the instrument. This instrument differs in safety

from `AAA' instruments only marginally.

A(so) This rating indicates adequate degree of certainty regarding timely payment

of financial obligations on the instrument. Changes in circumstances can

adversely affect such instruments more than those in the higher rated

categories.BBB(so)

(Triple B

This rating indicates a moderate degree of certainty regarding timely

payment of financial obligations on the instrument. However, changing

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SO) circumstances are more likely to lead to a weakened capacity to meet

financial obligations than for instruments in higher rated categories.BB(so)

(Double B

SO)

This rating indicates inadequate degree of certainty regarding timely

payment of financial obligations on the instruments. Such instruments are

less susceptible to default than instruments rated below this category.B(so) This rating indicates high risk and greater susceptibility to default. Any

adverse business or economic conditions would lead to lack of capability or

willingness to meet financial obligations on time.C(so) This rating indicates that the degree of certainty regarding timely payment

of financial obligations is doubtful unless circumstances are favorable.D(so) This rating indicates that the obligor is in default or expected to default.Note : 1) CRISIL may apply "+" (plus) or"-" (minus) signs for ratings from AA to

C to reflect comparative standing within the category.


rating symbols.

Foreign Structured Obligations (Fso) Rating Scales

The credit rating agency has developed a framework for rating the debt obligations of

Indian corporates supported by credit enhancements extended by entities based outside the

country. The issues considered inter alia include the credit worthiness of the offshore

entity, the nature and structure of the credit enhancement mechanism to ensure timelypayments on rated debt obligations an regulatory issues as regards the transfer risk. The

credit rating would notch up the standalone credit ratings of these Indian issuers depending

on all these factors.

CRISIL ratings of Foreign Structured Obligations (fso) factor the credit enhancement

extended by an entity based outside the country. The ratings indicate the degree of certainty

regarding timely payment of financial obligations on the instrument. These ratings have

been assigned in the current regulatory framework as regards the transfer risk and any

change therein could impact the ratings.

The credit enhancements could be in the form of guarantees, letters of credit, asset backing

or other suitable structures. Due to the current regulatory controls on inward remittances,

CRISIL would require suitable liquidity mechanisms to be in place for ensuring timely

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payment on due dates.

Foreign Structured Obligations ratings are based on the same scale (AAA through D) as

CRISIL ratings for long-term instruments. Foreign Structured Obligations ratings symbols

are defined below:

High Investment GradesAAA(fso)

(Triple A)*

Highest Safety - This rating indicates highest degree of certainty regarding

timely payment of financial obligations on the instrument. Any adverse

changes in circumstances are most unlikely to affect the payments on the

instrument.AA(fso)

(Double A)*

Highest Safety - This rating indicates high degree of certainty regarding

timely payment of financial obligations on the instrument. This instrument

differs in safety, from "AAA(fso)" instruments only marginally.

Investment GradesA(fso) * Adequate Safety -This rating indicates adequate degree of certainty

regarding timely payment of financial obligations on the instrument.

Changes in circumstances can adversely affect such instruments. Changes

in circumstances can adversely affect such instruments more than those in

the higher rated categories.BBB(fso)

(Triple B) *

Moderate Safety - This rating indicates a moderate degree of certainty

regarding timely payment of financial obligations on the instrument.

However, changing circumstances are more likely to lead to a weakened

capacity to meet financial obligations than for instruments in higher rated

categories.

Speculative GradesBB(fso)

(Double B) *

Inadequate Safety - This rating indicates inadequate degree of certainty

regarding timely payment of financial obligation on the instrument. Such

instruments are less susceptible to default than instruments rated below this

category.B(fso) High Risk - This rating indicates high risk and greater susceptiblity to

default. Any adverse business or economic conditions would lead to lack

of capability or willingness to meet financial obligations on time.C(fso) Substantial Risk - This rating indicates that the degree of certainty regarding

timely payment of financial obligations is doubtful unless circumstances

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are favorable.D(fso) Default - This rating indicates that the obligation is in default or expected to

default.

Note: The contents within Parenthesis are a guide to the pronunciation of

the rating symbols.Credit Rating Scale for Financial Strength Ratings (FSR )

Ratings are broadly divided into two categories - Secure and Vulnerable. Rating categories

from "AAA" to "BBB" are classified as 'secure' ratings and are used to indicate insurance

companies whose financial capacity to meet policyholder obligations is sound. Rating

categories from "BB" to "D" are classified as vulnerable ratings and are used to indicate

insurance companies whose financial capacity to meet policyholder obligations is

vulnerable to adverse economic and underwriting conditions.

The opinion does not take into account timeliness of payment or the likelihood of the use of

a defense such as fraud to deny claims. For insurance companies with cross-border or

multi-national operations, including those conducted by branch offices or subsidiaries,

ratings do not take into account any potential that may exist for foreign exchange

restrictions to prevent policy obligations from being met. Financial strength ratings do not

refer to an insurance company's ability to meet non-policy obligations (i.e. debt

contracts).The ratings are not recommendations to purchase or discontinue a policy,

contract or security issued by an insurance company nor are they guarantees of financialstrength.

Secure Ratings

AAA Reflects Highest Financial Strength to meet policyholder obligations. Though the

circumstances providing this strength are likely to change, such changes as can be

envisaged are most unlikely to affect adversely the fundamentally strong position.AA Reflects High Financial Strength to meet policyholder obligations. Though the

circumstances providing this degree of strength are likely to change, such changes

as can be envisaged are most unlikely to affect adversely the fundamentally strong

position. Companies in this category differ only marginally from the 'AAA' rated

insurance companies.A Reflects Adequate Financial Strength to meet policyholder obligations. However, change

in circumstances can adversely affect such companies more than those in the

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higher rated categories.BBB Reflects Moderate Financial Strength to meet policyholder obligations. However,

changing circumstances are more likely to lead to a weakened capacity to meet

policyholder obligations than the higher rated categories.

Vulnerable RatingsBB Reflects Inadequate Financial Strength to meet policyholder obligations. While

companies rated in this category are less susceptible to default than other

speculative grade companies in the immediate future, the uncertainties that they

face could lead to inadequate capacity to meet their policyholder obligations.B Reflects Greater Susceptibility to default on policyholder obligations. While current

obligations are met, adverse business or economic conditions would lead to lack of

ability or willingness to meet policyholder obligations.C Vulnerable to default. Ability to meet policyholder obligations is possible only if

favourable circumstances prevail.D In default. Current policyholder obligations are in default. Insurance companies

rated "D" are extremely speculative and policyholder obligations may be realized

only on reorganization or liquidation.

Financial strength ratings from "AA" to "BB" may be modified by use of a plus (+) or (minus

(-) sign to show the relative standing of the insurance / reinsurance company within the

rating categories.

Bond Fund Rating Scales

AAAf The funds portfolio holdings provide very strong protection against losses from

credit defaults.AAf The funds portfolio holdings provide strong protection against losses from credit

defaults.Af The funds portfolio holdings provide adequate protection against losses from

credit defaults.BBBf The funds portfolio holdings provide moderate protection against losses from

credit defaults.BBf The funds portfolio holdings provide inadequate protection against losses from

credit defaults.Cf The funds portfolio holdings have factors present which make them vulnerable to

credit defaults.

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Rating Process & FrameworkRating Process & Framework

Rating is an interactive process with a prospective approach. It involves series of steps. The

main points are described as below :

( a ) Rating request : Ratings in India are initiated by a formal request (or mandate ) from

the prospective issuer . This mandate spells out the terms of the rating assignment .

Important issues that are covered include : binding the credit rating agency to maintain

confidentiality , the right to the issuer to accept or not to accept the rating and binds the

issuer to provide information required by the credit rating agency for rating and subsequent

surveillance.

( b ) Rating team :The team usually comprises two members. The composition of the

team is based on the expertise and skills required for evaluating the business of the issuer.

( c ) Information requirements : Issuers are provided a list of information requirements

and the broad framework for discussions. These requirements are derived from the

experience of the issuers business and broadly conforms to all the aspects which have a

bearing on the rating. These factors have been discussed in detail under Rating framework.

(d) Secondary information :The credit rating agency also draws on the secondary sources

of information including its own research division. The credit rating agency also has a

panel of industry experts who provide guidance on specific issues to the rating team. The

secondary sources generally provide data and trends including policies about the industry.

(e) Management meetings and plant visits : Rating involves assessment of number of

qualitative factors with a view to estimate the future earnings of the issuer. This requires

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intensive interactions with the issuers management specifically relating to plans , future

outlook , competitive position and funding policies.

Plan visits facilitate understanding of the production process , assess the state of equipment

and main facilities , evaluate the quality of technical personnel and form an opinion on the

key variables that influence level , quality and cost of production. These visits also help in

assessing the progress of projects under implementation.

(f) Preview meeting:After completing the analysis, the findings are discussed at length in

the internal committee, comprising senior analysts of the credit rating agency. All the

issues having a bearing on the rating are identified. At this stage , an opinion on the rating

is also formed.

(g) Rating Committee meeting:This is the final authority for assigning ratings. A brief

presentation about the issuers business and the management is made by the rating team. All

the issues identified during discussions in the internal committee are discussed. The rating

committee also considers the recommendation of the internal committee for the rating.

Finally, a rating is assigned and all the issues which influence the rating are clearly spelt

out.

(h ) Rating communication : The assigned rating along with the key issues is

communicated to the issuers top management for acceptance. The ratings which are not

accepted are either rejected or reviewed. The rejected ratings are not disclosed and

complete confidentiality is maintained.

( I ) Rating Reviews : If the rating is not acceptable to the issuer , he has a right to appeal

for a review of the rating . These reviews are usually taken up only if the issuer provides

fresh inputs on the issues that were considered for assigning the rating. Issuers response is

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presented to the Rating Committee. If the inputs are convincing, the Committee can revise

the initial rating decision.

( j ) Surveillance : It is obligatory on the part of the credit rating agency to monitor the

accepted ratings over the tenure of the rated instrument. As has been mentioned earlier, the

issuer is bound by the mandate letter to provide information to the credit rating agency. The

ratings are generally reviewed every year, unless the circumstances of the case warrant an

early review . In a surveillance review the initial rating could be retained or revised

(upgrade or downgrade ).

How Does the Ratings Process Work?

The process of Rating starts with the issue of the Rating Request by the issuer/ signing of

the Rating agreement. A detailed flow chart is as under:

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Limitations of Credit Ratings

A Credit Rating is an assessment carried out from the limited standpoint of credit risk

evaluation. A Credit Rating from rating agency therefore constitutes a current Opinion on

the credit quality of a specific issue of debt, in terms of the issuers ability and willingness

to meet principal and interest payments on rated debt instruments in a timely manner.

Credit Ratings are arrived at based on information obtained in the rating process. In

addition to management meetings and information provided by rated entities, the rated

entitys audited accounts, regulatory filings, and information provided by trustees form an

important source of information. CRISIL does not verify and validate all the information

that it uses for its ratings. However, reasonable due diligence is carried out on all

information used to the extent feasible to ensure that a meaningful and accurate rating

exercise is done (for instance, financial accounts are extensively adjusted to ensure that

they present a relevant picture of the financial position of an entity from a debt servicing

perspective, to the extent feasible).

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Rating process for Bank/Financial institutionRating process for Bank/Financial institution

Once we have received a request for a new rating of a bank (this should subsequently be

backed by a formal rating agreement), we follow the procedures outlined below:

1. Analyzing the Banks/FIs environment

It is first necessary to collect and analyze data relating to the it system in which the

Banks/FIs in question operates and to the place of the Banks/FIs within that system. This

process includes analysis of the relevant national Banks/FIs market and of existing and

potential competition in that market and also of the degree of concentration within it. It

requires examination of the role and functions of the Banks/FIs supervisory authorities in

the country in question, of the degree of state control (or decontrol) of that countrys

Banks/FIs system, of the requirements of public reporting Banks/FIs and of the

accounting practices that lie behind the figures publicly reported by Banks/FIs. On a still

wider scale it is necessary to take into account the requirements of the Basle G 10

Agreement on "International convergence of capital measurement and capital standards"

and subsequent interpretative statements from the Basle Committee (of international bank

supervisors).

2) Bank questionnaire:

Based on our initial analysis of publicly available data, we prepare a questionnaire for

presentation to the management of the bank to be rated. A copy of our "prototype"

questionnaire is attached as Appendix 1. This is intended to serve as a basis which may be

adapted for the particular circumstances of the bank being rated.

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3) Meeting with bank:

As already indicated, the next step is a meeting with senior management of the bank in

question to discuss and assess the data provided. Such meetings are usually arranged with

the bank's chief financial officer, but many of the more sophisticated banking groups and

banks now employ rating agency liaison officers. The length and number of meetings with

management depend on the complexity of the entity being rated, but, normally the first

time we rate a bank there will be one such meeting, and it will last for half a day to a day.

4) Analysis of the bank:

The Cramel Model comprises the following:

I. Capitals adequacy ratio

II. Resource raising ability

III. Asset quality

IV. Management & system evaluation

V. Earning potential

VI. Liquidity / Asset Liability Management

NO one factor has an overriding importance or is considered in isolation.

These entire six factors are viewed in conjunction before assigning rating.

In addition to the factors which constitute the CRAMEL, the size of the financial entity is

also an important parameter. The size of an entity in the financial sector, imparts it the

ability to with stand systematic shock, support that can be expected for the entity.

I CAPITAL ADEQUACY:

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Capital adequacy of an entity provides the necessary capital cushion to with stand credit

risks. While assigning a rating, it analyses the capital adequacy level and its sustainability

in the medium to long term. The analysis of capital adequacy encompasses the following

factors:

I.1 Size of capital:

The absolute size of a capital imparts flexibility to a bank / FI to withstand shock

and thus an entity with higher absolute capital is viewed favorably.

I.2 Quality of Capital (Tier-I Capital):

The proportion of Tier I capital or core capital of a bank /FI is the primary

indicator of the quality of capital .The level of Tier-I capital is given primary

importance when assigning rating for capital adequacy .Although the presence of

Tier-II capital does provide some cushion in the short to the medium term , the

Tier-II capital needs to be periodically replenished .It also analyses other issues

like the presence of hidden reserve and the percentage of the investment portfolio

marked to the market. These issues help in streamlining accounting policy

differential across various entities and have a bearing on the quality of capital.

I.3 Flexibility to raise Tier I capital:

An entity has the flexibility to raise Tier I capital either through internal accruals

or through the capital markets. The ability of the entity to access the capital market

to meet its Tier I capital needs and its ability to service the increased capital base is

considered while evaluating the flexibility of a bank /FI to support the increased asset

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base through earning is an important parameters in assessing sustainability of

capital adequacy .An entity which is able to sustain asset growth through internal

generation without impairing capital adequacy is viewed favorably.

I.4 Growth Plans:

Its factors the future growth plans of a bank/ Fi while analyzing capital adequacy

.The capital adequacy of the entity (although at currently high levels) would be

regarded as unsustainable , if it pursuing a strategy of high growth .

II Resource raising ability:

It analyses the resource position of the bank /FI in terms of its ability to maintain a low

cost , stable resource base .In the domestic context , the resource (funding) composition of

bank and FIs is very different .Bank are significantly deposit funded where as the FIs have

to depend on wholesale funds .

Although some FIs do raise retail funds, they are at a natural disadvantage (in raising retail

deposits) as compared to the banking sector in terms of the restrictions on the minimum

tenure and interest rates, the absence of a cheque issuing facility and a relatively smaller

branch network. Some of the FIs do have access to significant concessional funding from

the government if they are playing a role which is of policy importance t the country.

However, in general the dependence on wholesale funding attaches a degree of risk t the

funding profile of FIs.These risks (especially stability of resource) are partly mitigated by

the access that the all India Financial Institutions (AIFIs) have to funds from provident

funds and insurance sectors; these funds are of a retail origin .Given this basic distinction in

funding profiles between bank/FIs, the funding risk profile of bank / FIs is discussed

separately.

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The following issues are considered while analyzing the resources position of a bank.

II.1 Size of a deposit base:

A large deposit base provides stability to the resource position of a bank. The size

of a deposit base provides the bank, a critical mass for effectively managing its

cash flows and adds considerably to the diversity (in term of the number of

deposits) of the deposit base.

Diversity in the deposit base & in term of large numbers of small ticket size

deposit, the geographically spread and the optimal rural /urban mix, lend stability

to the resources position of a bank. The number of branches and their

geographical spread lend diversity to the deposit base of a bank. Thus a bank with

large number of branches, dispersed all over India and an optimal rural / urban

mix is viewed favorably.

II.2 Deposit Mix:

The deposit mix of a bank has an impact on the cost of deposits. A high

proportion of saving and current deposit, signify a well entrenched deposit base

and lead to a stable and low cost resource base. It also analyses the trends in

deposit mix to form an opinion on the future stability and costs.

II.3 Growth in deposit:

Accretion to deposit is the main source of funding asset growth, and managing

liquidity risk in bank .It compares the growth in deposit of a bank with industry

trends to make relative judgements.

II.4 Cost of deposit:

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Cost of deposit is a function of deposit mix of the bank, its region of operation

and the bank to attract deposit at lower rates. Bank which have a low cost of

resources, not only benefits through higher profitability but also have a higher

flexibility to maintain their resources position, in the face of increasing

competition. The relevant issues while analyzing the resources position of a FIs:

II.5 Diversity of investor base:

Given the fact that the FIs are predominantly wholesale funded, the diversity of

the investor population (both domestic and international) does mitigate the risk

profile to a certain extent .FIs which is dependent on a few investors are viewed

less favorably.

II.6 Funding mix and cost of funds:

Traditionally, all the FIs enjoyed concessional funding from the government in

the form of SLR bonds. This facility has been progressively withdrawn from the

institutions and they have been increasingly accessing market borrowing over the

past few years.The mix of funds between the government and market borrowing

over the past few years. The mix of the funds between the government and market

borrowed funds is an important determinant of the overall cost of funds for an FI.

FIS which still carry a significant proportion of concessional funds on their books

will tend to enjoy a cost of funds advantage in the near terms.

The funding mix between domestic and foreign currency funding is also

examined to determine the overall risk profile .FIs which tend to have a higher

proportion of a foreign currency borrower defaulting on payment obligation and

thus exposing the FI to currency risk.

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This risk assumes significance in the current context, when the economy is

slowing down and there is a greater instance of corporate defaults. In case of FIs

which have been significantly dependent on foreign currency multilateral funds,

the recently imposed economic sanction would affect their resource raising

capabilities.

II.7 Retail Penetration:

Some of the leading FIs have started tapping the retail market for bonds and

deposits. These funds do impart stability to the funding mix and the trends in

raising retail resource are factored favorably into its risk evaluation

III ASSET Quality:

Asset quality of bank/FIs is a measure of the ability of the bank to mange credit risks.

Its analyses the asset quality on the basis of the following parameters:

Geographical diversity and diversity across industries:

Geographical diversity of an asset base and diversity across industries, along with single

risk concentration limits are important inputs in determining the asset quality of bank/FIs.

Industrial development of the states in the western region, like Maharashtra and Gujarat

is relatively higher. Thus, the amount of credit extended in this region is higher

concentration of advances in the western region .However , the bank /FIs with all India

presence have the additional flexibility due to their widespread branch network , to enhance

their exposure to other region , in case of adverse economic development in these states

.However , the regional banks with limited operation and branch network have lesser

flexibility to diversify their advances portfolio and are thus susceptible t adverse economic

condition in a particular region.

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Diversity across industries is largely a function of the geographical presence of the

Bank/FIs and Management policy. The industry exposure and single risk concentration is

monitored by the central bank through exposure guidelines. However, some bank/FIs show

a high degree of exposure t certain industries thus making themselves vulnerable to

downturns in those industries.

III.1 Client Profile of the corporate asset portfolio:

Credit quality of the corporate portfolio of the bank is an important input in the

analysis of the asset quality .It analyses the profile of the client in the asset

portfolio to make a judgement on portfolio quality. The ability of bank/FIs to

attracts better credit quality, especially after the dismantling of consortium

lending. The size (of capital) of a financial sector entity lends considerable

flexibility to the entity to attract larger and better quality clients given its sheer

ability to take on larger exposure in its balance sheet. Also, the ability of the

entities to attract and retain good quality clients by providing value added service

would enhance asset quality in the future.

III.2 Quality of Non-industrial lending:

Bank in India have an obligation to lend a proportion of their funds to the priority

Sector which primarily encompasses agriculture and small scale industries. To

this extent, FIs are better placed than banks because they do not have any such

obligation. It analyses the credit quality of this non-industrial portfolio in arriving

at a judgement on an overall asset quality of a bank. The credit quality of the asset

portfolio is also indicated by the segment wise NPA levels of the portfolio,

indicates the performance of the bank in each segment. This help in gauging the

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relative strength of the bank in each of the loan segment. Some of the banks have

a higher level of exposure to the trading. These advances provide a comparatively

higher yield and also provide diversity due to their small ticket size. The Indian

banks have to compulsorily lend 40% of their total advances to the priority sector.

The break up of the loan within these sectors in an important indicator of the

quality of the portfolio .E.g. An agricultural loan in an agriculturally prosperous

state of Punjab would have a better probability of being repaid as compared to

other agriculturally weak states.

Retail consumers loans (primarily vehicle and housing loans) still do not

constitute a major portion of the asset profile of bank/FIs. However, some large

bank/FI is strategizing towards a universal bank strategy and proposes to expand

significantly in this segment. It looks at the quality of retail consumers credit

growth and its final analysis.

III.3 NPA LEVEL:

The asset quality of a bank depends not only on the credit quality of its but also

on the ability of the bank to manage its asset portfolio. The NPA figures at gross

and net levels help in benchmarking the bank/Fish ability to manage their

portfolio, on a relative scale. While the gross NPA levels are an indicator of the

inherent quality of the asset portfolio of the entity and thus the credit appraisal

capabilities, the net NPA levels are an indicator of the balance sheet strength of

the bank, The NPA levels also indicate the proportion of earning asset of the bank

and the potential credit loss of bank. The proportion of earning asset and the

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potential credit loss would have a bearing on the future earning capability of the

bank.

Movement of provision and write offs:

Some bank/FIs follow a practice of their bad loans, in large portion of their bad

loans, in order to clean up their balance sheets.

Thus the present NPA numbers are not a true indicator of the banks asset

portfolio .Hence, NPA levels alone, cannot be criteria to assess future asset quality

of the bank. Average provisioning including write-offs, over a five years time frame is

an indicator of the levels cleaning up done by the bank, over the years, in order to

reduce its NPA levels. The amount of provisioning done is also an indicator of the

inherent credit quality of the asset portfolio. The average provisioning levels and its

movement serve as indicators of the credit risk of the portfolio and the expected

future write-offs and provisioning which would further affect the earning capability

of a bank.

III.4 Growth in advance:

High growth rates in the financial sector bring the establishment of collection

systems, tracking of asset quality and low seasoning of the lending portfolio. It

closely analyses the pattern and nature of growth .It studies the entities with

higher growth rates more carefully to look at the nature of growth, reason growth

and its implications on the asset quality. An entity which has grown by attracting

good quality clients from its competitors would be viewed more favorably as

compared to one which has grown by attracting good quality clients from its

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competitors would be viewed more favorably as compared to one which has

grown just by increasing its geographical presence or diluting credit criteria.

IV Management and system evaluation:

It believes that the quality of management can be an important differentiating factor in the

future performance of the bank/FI. The analysis of the management is carried out on the

following parameters.

IV.1Goals & strategies:

The future goals and strategies of the bank are evaluated to take a view in the

vision of the bank management. The ability of bank to adapt to the changing

environment and their ability to mange credit and market risk , especially in a

scenario of increasing deregulation of the financial market assumes critical

importance.

IV.2 System & monitoring:

It studies the credit appraisal system for managing and controlling credit and

market risk at a portfolio levels. Significant emphasis is laid on the risk

monitoring system and the periodically and quality of such monitoring. Most

Indian banks face the challenges of enhancing their information system and quality

of information reporting. The degree of acceptance of new system and procedure in

the bank, data monitoring systems and the extent of computerization within the

bank is given significant importance .The level of computerization is gauged on the

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basis of the extent of the business covered by computerization, the computerization in

branches and computerization of money market and forex market desks.

It attaches significance to the operating system for data capture and MIS reporting

in a bank .A bank balance sheet with a large volume of operating system in the

bank, and is viewed negatively.

IV.3Appetite for risk:

A high risk propensity of a management , typically reflect in the higher volatility

in earning in both fund based as well as non- fund based business .A management

with a higher propensity to take risk is viewed cautiously.

IV.4 Motivation level of staff:

The motivational level of employees would direct affect the service level of the

bank which is a key success factor in a market driven environment.

V Earning Potential:

It analyses on the following basis of the level

V.1 Level of earning:

It is measured by return on total asset provides the cushion for its debt service,

and also increases the ability of the bank to cover its asset risk. The ROTA is a

function of interest spread, expenses levels provisioning levels and the non- interest

income earned by the bank.

The size of net profit is also factored while rating of the entity. Earning of the

bank /FIs has been affected due to the volatility in interest rates. Thus, the trend

in profitability at gross profit levels is examined over the past levels is examined

over the past years to take a view on the sustainability of earning. The various

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elements leading to the profitability like net interest income, non-interest income ,

expense levels and the provisioning levels are also analyzed to take and the

sustainability of profits in future.

V.2 Diversity of income sources:

It is an important input in analyzing the stability of earning. Diversity of income

sources between various categories of funds based income like industrial portfolio

, retail portfolio, etc. lends stability to the income streams through non-interest

income like guarantees, service charges from its retail customer, trading income,

etc. The non-interest income provides cushion to the profitability, especially

which have the capability to provide better value added service would be in a

better placed to improve their fee based income. A closer analysis the

composition of the revenue streams, help in taking a view regarding the

sustainability of the earning.

VI Liquidity/Asset Liability Management:

It assesses the liability maturity profile of the entity to form an opinion on the liquidity risk

as well the interest rate risk.

VI.1 Liquidity risk:

It factors the resources strength of the bank in form of access to call borrowing

and the extent of refinance available from RBI. The bank are the primary channel

through which retail saving are channeled back into the public sector bank having

a wide spread branch network act as conduits for mobilization of retail saving . It

views most of the public sector bank favorably on the liquidity support available

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to the liquidity support available to the bank in the form of call money and RBI

refinance.

VI.2 Interest rate Risk:

The rating factor the volatility of the bank /FIs earning to interest rate changes .It

analyses the asset liability maturity profile of an entity to judge the level of interest

rate risk carried by the entity. In the Indian banking system, the interest rate and

maturity profile of the asset and liabilities have an inherent mismatch. the floating rate

advances portfolio (linked to prime lending rates ) and the relatively long duration

investment portfolio are funded through short to medium tenure liabilities which

exposes the bank to an element of interest rate risk.

FIs do score over bank in this regard due to the whole sale nature of their

operation and policies which link the nature of their operation and policies which

link the nature of borrowing (fixed/ floating ) with corresponding matched lending

.On an overall basis , FIs carry relatively lesser interest rate risk as compared to

the bank.

Parent support:

It factors the parentage of the entity in the final rating decision .The extent of support

factored is a function of the relative size of the two entities, the credit quality of the parent

and the strategic importance of the subsidiary to the parent .It positively factors the system

support for specialized entities in the financial sector, which have a policy role in the

national economy.

5. Draft report:

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Following the meeting with its management and subsequent analysis of the data obtained,

the analysts draft a rating report on the bank. Depending on the rating agreement and the

particular circumstances, this may be a short-form report (one page of text forming the

rating report, plus spread sheets) or a long-form report (one front page of text forming the

rating report, plus ca. five pages of text providing our rating analysis, plus spread sheets,

plus spread sheet annex, providing explanatory notes to the spread sheets). The analysis in

the text of the long-form report is arranged under main and sub- headings which tie in with

the topics covered in the bank questionnaire.

6. Presentation of draft report to bank

We send our draft report (without ratings) to the bank being rated, for two reasons:

- so that its factual accuracy may be checked;

- to allow management to determine whether we have included any information in our draft

which was given in confidence and which should be excluded on these grounds.

7. Amendment and subsequent circulation of report to rating

committee; composition of the committee

We amend our report in accordance with any comments from the bank which meet the

criteria in 6., above, and circulate it together with other, relevant documentation among the

members of a rating committee, which normally has a complement of five.There is no

single, standing rating committee; rather there is a committee for ach country we cover, or,

in some cases, for each peer group of banks in each country. The two analysts who visited

the bank, did the analysis and wrote the report are always members of its rating committee.

8. Rating committee meeting; assignment of ratings

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At the rating committee meeting the two analysts responsible for the work done so far

present the rest of the committee with the report they drafted, which has since been seen by

the bank and possibly amended, as explained above, to accord with its comments. They

also present relevant confidential data, which they have not been able to include in the

report, and peer group analyses comparing the bank with its domestic and foreign peers.

The ratings implied by the formula are not treated as definitive: they are considered only as

further input to the rating decision so that there remains a strong subjective element in our

final judgements - a subjectivity tempered, we trust, by several years experience (allowing

a reasoned extrapolation of the future), by common sense and by specialized knowledge

and research.

9. Dissemination (or non-dissemination) of the ratings

When a bank being rated for the first time has been informed of the decision of the rating

committee, it has no recourse to an appeal, but it does have the right to decide whether it

wishes our ratings to be made public and the rating report to be sent to our subscribers.

However, normally before launching ourselves into the work involved in a new rating,

which possibly also involves coverage of a country which is new to us, we would have

tried to provide the entity being rated with an "indicative" rating. That is to say, on the

basis of a brief analysis of the data available to us we would provide a range of likely

ratings within our rating scales so that the bank being rated has from the start an

approximate idea of what its ratings will be. In the event that the bank does accept that

publication should take place, then the rating report and the ratings will be dispatched to

our subscribers who include over 1,200 major institutions worldwide. In addition, our

ratings will be made available to the public by means of the "wire" services, press releases,

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etc. If the bank does not want the ratings published and the report disseminated, then the

project will be terminated, and regular subscribers will not be informed that we have done

rating work on the bank concerned.

CASE REPORTCASE REPORTCase I

The Federal Bank Limited

National

Subordinate Debt A+(ind)Rating Outlook Stable

Foreign Currency

Short-term Senior -Long-term Senior -Long-term Rating Outlook -

International

IndividualSupport 5T

Sovereign Risk

National AAAForeign Currency Long-term BBSeniorLocal Currency Long-term BB+

SeniorFinancial Data

The Federal Bank Limited

31/03/2002 31/03/2001

Total Assets [US$ mn] 2,104.7 1,891.1Total Assets [INR mn] 101,446.1 88,200.4

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Equity [INR mn] 4,487.9 4,154.7 Net Income [INR mn] 820.1 610.4ROA [%] 0.86 0.74ROE [%] 18.98 15.70Equity/Assets [%] 4.42 4.71

Rating Rationale

Assessment

The ratings of The Federal Bank Limited (FBL) reflect its relatively small size, average

financial profile and long operating history. With a large proportion of its branches and

business concentrated in its home state of Kerala, the Bank enjoys a strong franchise

among depositors in the state and the expatriate Keralite community. FBLs pursuit of

rapid loan and asset growth since the mid-1990s (its loan book has grown by over three

times since FY95) without commensurate credit appraisal and risk management systems,

coupled with a slowdown in the economy has resulted in a deterioration of its asset quality.

Gross and net NPLs as a proportion of gross and net advances have risen over the years and

were at 11.82% and 7.36% for end-September 2002. FBLs loan loss reserve coverage

improved to 40% at end-September 2002 from 29.2% at end-FY02. Its net NPLs to equity

ratio, although improved, was still high (at over 77%) in comparison to some of its peer

banks. Although FBLs total capital ratio of 10.63% (Tier 1 ratio was 6.96%) at end-

March 2002 was above the regulatory minimum of 9%, its low capital base is reflected in

its low equity to asset ratio of 4.42%, emphasising the need to bolster the Banks equity

base, especially Tier 1, to enable it to better absorb the present and future asset quality

shocks and support its planned asset growth. Of FBLs total deposits, NRI deposits form a

substantial proportion and these, along with the term deposits, render its funding base

stable, but expensive. The Bank is focussing on reducing its funding costs by increasing the

share of lowcost savings and current deposits by enhancing its reach through an increased

branch and ATM network. As against the general industry trend, FBLs net interest

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margins have improved in the last couple of years on the back of declining average funding

costs and higher average yields from its retail loan portfolio. Net Interest Margin (NIM) at

3.1% was better than its peer group banks. Backed by higher operating income, FBLs

cost-to-income ratio improved to 38.5% for end-FY02 from 56.7% in FY00. With its

loan-to-deposit ratio consistently above 55%, FBLs reported liquidity ratios were low.

FBL reported some mismatches in its asset-liability maturity in the short term, although

these are mitigated by high deposit renewal rates.

Support

FBL has no identifiable controlling shareholder, and while its existing shareholders are

likely to be willing or able to provide support to the Bank as a going concern, it is less

clear whether they will be willing or able to provide resources in an extreme situation.

Although RBI has a good track record of supporting banks in times of need, FBL is a

small player in the banking system. In our opinion, therefore, support is possible, should

that be necessary, but it cannot be relied upon. The 'T' suffix to our Support rating indicates

certain subinvestment grade features of the Indian economy that could limit support for

foreign currency creditors.

Background

The Federal Bank Limited was established in 1931 as the Travancore Federal Bank Ltd..

The Bank was listed on local bourses after its initial public offering in 1994. The ICICI

group is the single largest shareholder, with 21.35% of the Banks equity, while public

holding was 61.72% as at end-June 2002. FBL primarily lends to mid-size corporates,

small and medium enterprises and individuals, and is now focussing on highly rated large

and medium corporates and the retail sector.

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PROFILE

An old private sector bank; operates as a regional bank with high concentration of

business in its home state of Kerala.

Focus shifting from corporate to retail banking.

Established as a private sector bank at Nedupuram in the southern state of Kerala by a

small group of local citizens, The Federal Bank Limited changed its headquarters to

Alwaye in 1945. The Bank was established to cater to the banking needs of traders and

agriculturists. Over time, as a large proportion of the local population migrated to other

countries, especially the Middle East, FBL also catered to the local banking needs of these

expatriates. In the 1960s, the Bank took over five other small banks and became a

scheduled commercial bank in 1970. FBL was listed on domestic bourses after its initial

public offering in 1994, and in 1996 held a successful rights issue. Prior to its IPO the Bank

had privately placed equity with the IC ICI group, which continues to be the single largest

shareholder. The shareholding pattern as on June 30, 2002 is given in

Table 1: Shareholding Pattern of FBL

Category % of

ICICI Group 21.35

Mutual Funds and Unit Trust of India 4.82

Foreign Institutional Investors 1.50

Banks, FIs, NRIs and OCBs 2.11

Individual Public Shareholders 61.72

Source: The Federal Bank Limited, Fitch

Apart from providing its customers with traditional retail and commercial services, FBL

has an active treasury. In FY2000, the Bank decided to cease the operations of its wholly

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owned subsidiary Fedbank Financial Services Limited that was engaged in the business

of hire purchase, leasing and merchant banking due to an unfavourable environment

affecting non-banking finance companies in general, and the company now exists only as a

shell company with a core capital of INR5 million. FBL has links with 13 exchange houses

and seven banks in the Middle East for providing foreign currency remittance facilities to

its customers, especially in the Middle East. The Bank has an agreement with ICICI

Prudential Life Insurance to undertake distribution of life insurance products. FBL also

offers Depository Services to its customers. FBL has the largest branch networks amongst

the old private sector banks. As of March 31, 2002, the

Bank serviced it customers through 416 branches and 62 ATMs. 73% of the Banks

branches are located in its home state of Kerala, and given the high concentration of its

business in the state, FBL can be viewed as a regional player in the banking sector. The

Bank plans to increase both its branch and ATM network to 500 each by FY06. FBL had

appointed Accenture, an international management consulting group, to conduct an

organisational restructuring study for the Bank. The consultants have submitted their report

and recommendations and the Bank is now working on implementation of these.

Technology: FBL has automated all of its branches using its in-house banking software

FedSoft. At present, 74 of its branches are interconnected through leased lines with plans

to switch to a Wide Area Network (WAN). The Bank already offers Internet banking under

the brand name FedNet in addition to mobile and telephone banking. FBL has invested

INR650m in its IT initiatives and plans to invest an additional INR 1 billion over the next

three years for interconnecting its branches, expanding its ATM network, extending its

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current mobile and telephone banking capabilities and to migrate to a centralised banking

solution from the current hub and spoke set-up.

PERFORMANCE

Weak, but improving, asset quality requiring higher loan loss provisions have

constrained FBLs profitability.

Improving net interest margins despite high funding costs and declining yields on

loans and investments.

Post liberalisation in the early 1990s, FBL pursued aggressive loan and asset book

expansion, but faced asset quality problems on account of prolonged economic slowdown

and its own weak credit appraisal and monitoring systems, requiring increased loan loss

provisions. This, coupled with declining interest rates amidst intensifying competition, has

adversely impacted the Banks performance. ROA and ROE, which were at 1.3% and

30.73%, respectively, in FY95, have since declined to 0.86% and 18.98%, respectively, in

FY02.

Net Interest Revenue: Net interest income (NII) continues to the predominant source of

revenue for FBL, although its share in total operating income has declined to 55.6% in

FY02 compared to 68.75% in FY95. After recording a sharp decline in its NII in FY99 on

account of a steep rise in its interest expenses, the Banks NII has grown nearly three times

since then. NII growth at 16.6% in FY02 continued to be healthy, though it was below the

34.5% growth recorded in FY01. Interest expenses, which had declined during FY01 and

FY00, grew by over 12% during FY02 on the back of substantial deposit growth in last two

years, which explains the lower NII growth rate.

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As against the general industry trend,

substantial decline in its NII), and its

NIM at 3.1% FBLs net interest

margins (NIM) have improved after

recording a sharp decline in FY99

(which was due to for FY02 was better

compared to its peers old private

sector banks as well as some of the

better- performing government banks. Although declining, FBLs average funding costs

at 8.9% for FY02 continued to be high, and the bank is focussing on reducing this further

by cutting the interest rates on its high cost foreign currency NRI deposits and increasing

the share of low cost retail deposits by enhancing its delivery capabilities.

Non-interest Income: FBLs non-interest incomes are primarily derived from its treasury

money market and foreign exchange and trade finance related activities. The share of

non-interest income a fivefold increase in its profits from sale of in total operating income,

which had been declining since FY99, grew to 44.4% in FY02 primarily due to

investments, mainly Government securities (G- Secs). In the last couple of years, most

Indian banks have built up government securities investments in excess of reserve

requirements as there has been a dearth of quality lending opportunities and the

declining interest rates provided increased arbitrage opportunities on these investments.

Profits from trading in G-Secs have continued in H1 FY03, and annual profits in 2003 from

this business are projected at the same level as FY02.

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FBLs total non-interest income grew

by over 76% in 0 FY02 compared to a

contraction of 5.4% in the previous

year. While the growth was fuelled by

a 560% rise in its income from G-Sec

trading, its other non-interest incomes

declined during FY02. A high

proportion of treasury income adds an

element of volatility to the Banks revenue profile, and it has entered into a number of

areas, including cash management services and distribution of third-party insurance, to

augment its non-interest income, in an attempt to ensure a more stable revenue profile and

maintain its profitability levels.

Operating Expenses: The large infrastructure maintained by Indian banks in terms of

branches and employees renders

their operating expenses high. FBLs

non-interest expenses have grown by

over two and a half times since FY95

on account of higher employee costs

on the back of two wage revisions

during the period. However, its cost-

to-income ratio has improved to

38.52% for FY02 compared to a high of 75.45% in FY99. Employee costs continue to be

the major contributor, accounting for over 63% of total operating expenses and 1.36% of

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average earning assets. Going forward, FBLs operating expenses are expected to rise

further in view of the on-going expansion of its branch and ATM network as well as

technology related and other operating and marketing expenses. However, given the

improving operating income levels, the cost-to-income ratio is not expected to rise

significantly.

Loan Loss Provisions: The rapid expansion to the banks loan book since the mid-1990s

(loans and advances grew by over

three times since FY95), coupled with

the pronounced slowdown in the

Indian economy and progressively

tightening prudential norms, have

adversely impacted FBLs asset

quality necessitating higher loan loss

provisions in recent years. While

FBLs total loan loss provisions grew by 54% in FY02, these have grown by over four

times since FY98. Loan loss provisions formed 51% of total pre-provision operating profits

for FY02. As a proportion of average loans these have grown to 3.1% for FY02 from

0.96% in FY99. FBLs loan loss provisions are expected to remain high in the medium

term, in view of its high level of NPLs amidst a weak macro-economic environment,

implementation of the 90-day default norm that takes effect from 31 March 2004 and the

building up of loan loss coverage by the Bank.

Half-Year Performance: As per the audited (limited review) results for the half-year

ended September 30, 2002 (H1 FY03), FBLs net income (profit after tax) grew by 1.9%

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and was supported by 11.9% growth in NII. Operating profits growth at 5% was

constrained by a 9.4% increase in total non-interest expenses during H1 FY03. Provisions

including loan loss provisions were higher by 3%. For FY03, FBL has projected higher

operating profits on account of improved net interest income (NII), while lower provisions

are projected to result in substantially higher net incomes (profit after tax).

Prospects: FBLs performance, to a large extent, is dependant on the economy of its home

state Kerala and its NRI deposits base. Saddled with a high level of NPLs, the Bank is

currently focusing on cleansing its balance sheet by reducing its NPLs, further

strengthening its credit risk measurement and management systems, reducing reliance on

costly NRI deposits and increasing the low cost retail deposits to reduce its funding costs.

In the short to medium-term, FBL is expected to benefit from higher treasury income and

its sustained recovery efforts resulting in improved asset quality. Given the intensifying

competition, amidst a generally declining interest rate environment, the Bank will be

required to develop its fee-based incomes for a more balanced revenue profile. Over the

long-term, we expect FBL to emerge a stronger player with a solid deposit franchise in

Kerala and a geographically diversified asset book.

RISK MANAGEMENT

Aggressive loan book growth and relatively weak credit appraisal and

monitoring in mid-1990s have resulted in weak asset quality.

FBL has been strengthening its risk management systems.

FBLs Board of Directors is responsible for setting up the Banks risk management policies

and has put in place the Risk Management Committee to implement policies and

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procedures to identify, monitor and manage risks including credit, market, liquidity and

operational risks. The Credit Risk Management Committee (CRMC), reporting to the

Chairman, measures and monitors the credit risk of the Banks loan portfolio, while the

Asset Liability Committee (ALCO) measures and monitors market and liquidity risks and

uses Earnings at Risk (EaR) for measuring the risk of its trading and banking

book. Recently, the Bank has also set up the Operational Risk Committee (ORCO) to

measure and monitor operational risks arising from the failure of people, processes,

products, technology, etc. Going ahead, the Bank is strengthening its risk management

systems through increased use of technology, training its staff in risk measurement and

management and prescribing stringent appraisal and monitoring norms for the risks faced

by FBL.

Credit Risk: FBL lends to corporates and small and medium-sized enterprises (SMEs) for

their working capital requirements and

trade financing. Large credits (greater

than INR50m) and lending to the SME

sector collectively accounted for over

80% of the Banks total loan book,

while retail and other loans made up

the balance. In FY02, growth in

FBLs loan book at 6.9% was lower

compared to FY01s 20.3%. Over 80% of the Banks loans are secured by collateral,

including inventory, receivables, land or plant and machinery. Additional security by way

of shares, as well as corporate or personal guarantees is obtained, wherever necessary.

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FBLs top four exposures to the industrial sector were to textiles (11.59%), food processing

(10.4%), iron & steel (9.8%) and real estate 8.4%.

FBL follows a credit rating model for all its credit exposures above INR50m, where they

are classified into 10 categories of risk grades from FB-1 to FB-10 (FB-1 being the best

and FB-10 being the worst). Borrowers are evaluated on various business an does not

qualify for assistance. The loan booked financial parameters and assigned a credit rating,

and any proposal failing to attain at least a FB-6 rating composition as per the Banks

credit ratings for end-FY02 is given in Table 2.

.Table 2: Loan Book Composition by Credit Ratings

(%) FB-1 FB-2 FB-3 FB-4 FB-5 FB-6 D

2.03 17.88 29.38 19.94 5.94 0.0 24.81

By end-FY03, FBL intends to assign credit ratings to all loans above INR200, 000, with

plans to review the ratings every six months, instead of the annual basis currently followed.

The Bank has been linking the pricing of its loans to its self-defined credit rating;

however, it maintains some flexibility in pricing, especially for top-rated credit accounts,

given the intense competition in this segment.

Loan Loss Reserves: FBL follows the RBI norms for classifying NPLs and providing for

loan losses, and these are somewhat liberal by international standards. A loan is classified

as an NPL when interest and/or principal are outstanding for 180 days. FBLs lending to

the real estate sector accounted for nearly 9.3% of the total gross NPLs as of end-FY02.

This was followed by loans to the iron & steel sector (5.5%) and non-banking finance

companies (3%).

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(INRm/%) FY 02 FY 01 FY 00 FY 99

Gross NPLs 6,380 6,420 4,900 4,790As % of Gross Loans 11.88 12.84 11.75 10.93

Loan Loss Reserves (LLR) 1,864.4 1486.0 1,389.9 1,562.9

LLR to NPLs (%) 29.21 23.14 28.34 32.61

Net NPLs to Equity (%) 99.34 117.78 95.31 98.61

Net NPLs to Net Loans (%) 8.60 10.08 8.56 7.53

Grading of Net NPLs (%)

Sub-standard 52.41 63.16 - -

Small-Doubtful 47.53 47.53 36.84 - -

Bad debts 0.0 0.0

Table 3: Trends in FBLs Asset Quality

FBL pursued aggressive loan book expansion in the mid-1990s, which was followed by a

prolonged economic slowdown, tightening asset classification and provisioning norms.

Due to FBLs relatively weak credit appraisal and monitoring mechanisms, this led

to a substantial deterioration in its asset quality. Both gross and net NPLs have grown in

absolute terms as well as a proportion of gross and net advances.Reported gross and net

NPLs as a ratio of gross and net advances, at 11.88% and 8.6% respectively, for end-FY02,

continued to be high. Application of the 90-day default norm, to be effective from March

31, 2004, would result in gross NPLs rising to over 17% of gross advances as at end-FY02.

However, under the RBIs monitor able action plan on FBL, the Bank has given an

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undertaking to bring its net NPL ratio below 7% by end-March, 2003. Net NPLs were

already down to 7.36% as of September 30, 2002. FBLs NPL composition deteriorated in

FY02 as doubtful assets as a proportion of total net NPLs increased to over 47% compared

to 37% in FY01 the previous fiscal primarily due to ageing of sub-standard assets, and

while this somewhat adds to our asset quality concerns, FBL has been able to contain fresh

accretion of NPLs in recent times. FBLs loan loss provisions had failed to keep pace with

the deterioration in its asset quality and this is reflected in its low loan loss reserve

coverage ratio, which stood at only 29.2% for end-FY02 from a high of 32.6% in FY99.

However, the coverage improved to 40% for end-September 2002 on the back of increased

provisioning, and if the technical write-offs are added back, the coverage improves further

to 57.4% as at end-September 2002. FBL plans to further reduce its NPL levels through

aggressive recovery efforts and increased loan loss provisioning. FBLs net NPLs to equity

ratio improved to 77.6% for end-September 2002 from 99.34% for end-FY02 and is

expected to improve further to about 56% by end-FY03.

Market Risk: As for most Indian banks, FBL is exposed to interest rate and liquidity risks

on account of a structural maturity mismatch arising from funding the loan and fixed-

income investment portfolio through short-term customer deposits. To a large extent these

risks are mitigated by high renewal rates and relatively stable nature of the Banks deposits

and because the bulk of the Banks loans are contracted on a floating rate basis. Even on

fixed-rate loans, the Bank reserves the right to re-price them periodically. In addition, the

Banks holds government securities in excess of reserve requirements and the portfolio has

witnessed appreciation in value on account of falling interest rates.

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FUNDING AND CAPITAL

Customer deposits, especially NRI deposits, have funded FBLs growth.

Low capitalisation levels; capital ratios under pressure due to expanding asset base

and high level of NPLs.

Funding and Liquidity: FBL, like most Indian banks, is predominantly funded through

customer deposits and these accounted for 91.7% of total deposits and money market

funding as of end-March 2002. However, the deposit mix has historically been skewed

towards relatively stable but costlier term-deposits, especially the foreign currency term

deposits on account of expatriation by non-resident Indians (NRI). These NRI deposits

form approximately 45% of the total deposit base, and nearly 61% of total deposits from

branches in the state of Kerala are NRI deposits. FBL plans to reduce its funding costs

through a two-pronged strategy. Firstly, the Bank intends to phase out the premium it pays

on its NRI Deposits, and secondly, it plans to increase the share of low-cost retail savings

and demand deposits through enhanced delivery capabilities in form of expanding branch,

ATM and Internet banking network and improvised retail liability products. Presently, the

bank reports high renewal rates of its term-deposits and the accretion to deposits has

consistently exceeded the repayments. Historically, FBLs credit to deposit ratio has been

relatively high at above 55%, and consequently its liquidity ratios have been somewhat

lower. While loans as a proportion to deposits and money market funding declined to

56.2% for end-FY02 compared to 60.6% in the previous year, these were still high

compared with most other banks, while its quasi-liquid assets (deposits with banks and G-

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Secs) comprised 33.1% of the Banks total assets. As FBLs is expected to continue

expanding its loan book in the medium-term, its liquidity ratios are expected to remain low

in the near future. The maturity profile of FBLs assets and liabilities as on March 31, 2002

over the next five years is shown in Table 4. FBL reports negative gaps in some of the time

buckets up to one year and in the one-to-three year time bucket. As most of these negative

gaps are on account of maturing customer deposits and given the fact that the Bank reports

a high renewal rate in case of term deposits (58% in case of domestic term deposits and

62% for NRI deposits) and high retention in savings and demand deposits, Fitch is of the

opinion that liquidity risk is substantially mitigated.

Capital: Continued growth in FBLs asset base coupled with tightening prudential norms

in recent years has led to decline in its capital adequacy ratio. FBLs reported total capital

adequacy ratio at 10.63% for end-FY02 was slightly above the regulatory minimum of 9%,

although its Tier 1 ratio at 6.96% was low, and in the absence of any fresh equity

raising, the Tier 1 ratio has hovered between 7% and 8% for the last four years. Further,

like most Indian banks, FBLs capital adequacy ratios are partly boosted by its holding of

low-risk G-Secs that accounted for nearly 26% of its total assets as of end-FY02.

Table 5: Trends in FBLs Capital Ratio

(%) FY 02 FY 01 FY 00 FY 99

Tier 1 6.96 7.72 7.72 6.48Tier 2 3.67 2.57 3.61 3.84Total 10.63 10.29 11.33 10.32

Equity/Asset 4.42 4.71 4.76 4.00

In the past decade, FBL enhanced its equity base on two occasions first in 1994 through

its initial public offering, and then in 1996 through a rights issue; since then its capital

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ratios have been supported by internal accretions and subordinated debt issuances. FBLs

capital ratios are expected to come under pressure as the Bank continues to expand and

addresses its asset quality problems through higher provisioning and write-offs over the

next few years. The low equity levels are also reflected by the Banks low equity to asset

ratio that has ranged between 4% and 5% and stood at 4.42% at end-FY02. This

emphasizes the need for the Bank to bolster its Tier 1equity levels going forward.

BALANCE SHEET ANALYSISThe Federal

Bank Limited

31

Mar

ch

31

March

2002

As

%

Of

of

Aver

age

31

Mar

ch

As

%

Of

31

March

2000

As

%

Of

31

Mar

ch

As

%

Of

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2002

(US

Dm)

(INRm

)

As

set

s

IN

R

m)

(INR

m)

2001

INR

m)

As

set

s

INRm) As

set

s

1999

INR

m)

Ass

ets

A Loans1.GuaranteedbyBanks/Gov

147.1 7,092.3 7.0 7,017.5

6,942.6

7.9 6,215.3 8.2 9,148.9

11.3

2. Secured 864.8 41,683.8

41.1

39,797.5

37,911.3

43.0

32,857.6

43.2

28,569.4

35.4

3. Unsecured 64.6 3,115.1 3.1 3,401.2

3,687.3

4.2 1,284.2 1.7 4,559.4

5.6

4. (Loan LossReserves)

n.a - 0.0 - - -

TOTAL A 1,076.6

51,891.1

51.2

50,216.2

48,541.3

55.0

40,357.1

53.1

42,277.7

52.4

B. OtherEarning Assets

1. Depositswith Banks

125.1 6,027.8 5.9 5,076.5

4,125.1

4.7 4,484.9 5.9 6,631.8

8.2

2. GovernmentSecurities

credit rating of bank financial by- vrushank mehta

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