Internal Credit Risk Rating Systems in the Macao Banking Sector *

Transcription

1 Internal Credit Risk Rating Systems in the Macao Banking Sector * Anna P. I. Vong Faculty of Business Administration, University of Macau Antonio Pires Patricio Faculty of Business Administration, University of Macau Abstract Internal credit risk rating systems are becoming an increasingly important element of commercial banks measurement and management of credit risk. Such an importance has in fact been highlighted in the proposed Basel Accord II that includes the internal rating approach to credit risk as one of its cornerstones. This paper attempts to investigate the extent to which the credit rating systems are used in Macao based on a recent survey. * This paper is based on an earlier article entitled Credit Risk Assessment in the Macau Banking Sector published in Euro Asia Journal of Management, Vol. 15, No.2, December

2 1. Introduction The increased number of bankruptcy cases worldwide, both corporate and personal, is the main reason for the renewed interest in credit risk management. A bad loan situation often arises from a combination of factors, amongst which the major one is the absence of an adequate system to classify loans properly and to identify problem loans promptly so as to minimise the potential defaults and consequent losses. More defaults mean more missed loan payments and a reduction in profitability for banks. Poor management of credit risk is considered to be the major cause of banks bad performance and often the reason for their bankruptcy. After the Asian financial crisis in 1997, there was an increase in problem loans in Macao. The financial soundness indicators had deteriorated since then, and the nonperforming loans loomed until 2003, the year when the negative trend started reversing. The non-performing loan ratio increased from the lowest level of 1.0% in 1993 to its peak of 22.0% in Some financial analysts attributed this surge to the ripple effect of the crisis and the loose loan policy that was adopted by the local banking sector during the rapid economic growth period. Since no debt market exists in Macao, banks have dominated the financial sector. They are the only deposit taking institutions and the sole providers of external funds to the economy. As such, the banking sector performs a significant role to ensure that the economy does not suffer from its poor performance. Based on a recent survey, this paper investigates the extent to which the credit risk rating systems are used in Macao and whether or not a difference in those systems exists between individual banks. The rest of the paper is organised as follows. Section 2 reviews the literature of credit rating while Section 3 presents the data and methodology. The empirical results are reported in Section 4, followed by the conclusion in the last section

3 2. Literature Review Banks manage a wide range of assets, liabilities, and equity capital that support their operations and activities. Proper risk management is therefore a vital and integral part of effective bank operation. Widely cited risks include credit risk, interest risk, liquidity risk and operational risk. All these risks are derived from banks most fundamental and traditional roles of lending and borrowing. Among those risks, credit risk, which is associated with the potential variability of the stream of cash flows from an asset, is one of the most crucial ones, as it is often appointed as the cause of a bank failure. To perfect its credit risk assessment, monitoring and management, banks use a variety of methods and tools. In the past 20 years, banks have been adopting and improving automatic credit scoring system 1 so as to evaluate certain types of loans more objectively, accurately and efficiently. Recently, the industry has started implementing credit rating as a mechanism to better manage its credit risk and to improve its overall portfolio performance. Credit risk rating is a summary indicator of risk for banks individual credit exposures and is generally assigned at the time of each underwriting or credit approval and reassessed during the credit review process. It functions as the barometer for the banks to measure their credit risk exposure to each individual customer, either in isolation or as part of their loan portfolio. The rating allows banks to measure the relevant default probabilities at different rating levels more accurately. It helps banks to reduce their risk exposure and to improve their profitability by reducing the number of potential default loans as well as minimising the cost associated with bad debt recovery. Although the major objective of credit rating is to determine the ability and willingness of a borrower to pay at the agreed terms, the rating does a bit more than just classifying the borrowers into pass and fail categories. The most important benefits for banks in using the rating system to assess their loans include: 1 Credit scoring is an application of a statistical model to assign values to characteristics of would-be borrowers (Sinkey 2002)

4 ! Identify and decline potential risky applicants! Reduce losses due to defaults! Price the loan properly! Increase liquidity! Maximise the profit! Improve monitoring process! Reduce monitoring cost! Minimise administrative costs with debt collection! Help banks to achieve their objectives! Allow allocation of resources where they are more productive! Avoid loan concentration Treacy and Carey (2000) suggest that in designing a credit rating system, a bank should consider numerous factors, including cost, efficiency of information gathering, consistency of rating produced, staff incentives, nature of a bank s business, and uses to be made of the internal ratings. They notice that the proportion of grades used to distinguish among relatively low-risk credits versus the proportion used to distinguish among riskier pass credits tend to differ with the business mix of a bank. A rating system with more rating categories is better than a system with just a few categories. Finer distinctions of risk, especially among riskier assets, can enhance a bank s ability to analyse its portfolio risk exposure. However, an internal rating system with larger number of grades is costly to operate because of the extra work required to distinguish finer degrees of risk. When assigning a loan applicant to a particular grade, Crouhy et al. (2001) suggest that banks should analyse three different categories of variables quantitative, qualitative and legal. The quantitative analysis concentrates mainly on financial analysis and is often based on a firm s financial reports. The four main quantitative factors used in the assessment model include net income, total operating income, total equity capital and total asset values. These factors allow the banks to calculate a variety of ratios including return on assets (ROA), return on equity (ROE) and assets utilisation (AU), etc. Once computed, these ratios would be compared with the

5 industry standard. In addition to the information disclosed in the financial statements, the rating also includes information about the quality of collateral and the third party support. For certain type of loans like overseas loans or loans for customer in import/export business, country risk is also another important factor to take into account. As for the qualitative analysis, the principal concern will be the quality of a borrower s management. A thorough review of a firm s competitiveness within its industry as well as the expected growth of the industry is needed. Finally, legal analysis refers to the capacity to borrow. This means that a bank must make sure that a customer requesting a loan has the authority and the legal standing to sign a binding agreement. For instance, a bank needs to check whether the representative from an organisation asking for a loan has the power to sign the credit agreement binding the organisation and whether it gets the first claim on the collateral. In case it is an individual asking for a loan, a bank needs to know if he can be held legally liable for the loan he is requesting. Despite the advances in science and technology that allow the development of expert system or statistical classification models, human judgment is still an important ingredient in the credit risk assessment process. According to Treacy and Carey (2000), the rating process almost always involves the exercise of human judgment because factors to be considered in assigning a rating and the weights given to each factor can differ significantly among borrowers. Indeed, experienced lenders take credit ratings and reports as inputs for decision-making process. The key reason for the models to be tempered with judgment and common sense is because they do not fully explain the subjective factors involved in the rating. Especially for large exposures, the benefits of such accuracy may outweigh the higher costs of the judgmental systems. Because of the high cost involved, in general, banks produce credit ratings for business and institutional loans only

6 3. Data and Methodology In order to understand the extent to which the credit risk rating systems are used in Macao and how the systems differ among banks, information is gathered from banks. Both questionnaires and interviews are employed in the study. Regarding the questionnaire, the majority of the questions were extracted from that used by English and Nelson (1998) 2 when examining the credit risk rating systems at large American banks. The questions attempt to investigate whether or not banks in Macao have a formal credit rating system in place, and to understand the scope, methodology, structure and purpose of such system. In addition, for those rating systems, the number of grades and the meaning attached to each of those grades will also be examined. Finally, to supplement the inadequacy of the questionnaire, interviews with executives and senior loan officers are also conducted. 4. Empirical Results Although the questionnaires have been distributed to 22 banks operating in Macao, only five of them have indicated interest to participate in the study. They not only offered to answer the questions but also granted interviews to provide additional information. First of all, the banks claimed that they follow the loan classification system laid down by the Monetary Authority of Macao (AMCM). In the system, loans are first discriminated into two broad categories, namely pass and delinquent. For the latter category, it is further differentiated, based on how late the principal and/or interest payment have been, into four classes (Table 1). 2 The authors duly authorised the use of the questions

7 Table 1: Regulatory Loan Classification System Length of Default Classification Provision Required Pass Pass At least 1% Delinquent Up to 3 months Group I At least 1% Over 3 and less than 12 months Group II 40% Over 12 and less than 18 months Group III 80% Over 18 months Group IV 100% The above five-category loan classification system has been criticised because the pass category does not differentiate among the pass loans, reflecting the narrow perspectives of the 1988 Basel Accord, which did not distinguish between an AAA credit (investment grade) and a junk credit (Sinkey 2002). Indeed, this classification system is not suitable for loans being requested but for loans that are already in the books of banks. It is mainly used for monitoring and reviewing loans as this system emphasises on the performance and the quality of loans that have already been made, taking into account mainly the period that the loan has been outstanding and the quality of collateral is considered as a mitigating factor. In fact, it is a framework for banks to prepare for the loan loss provisions, which need to be reported to the supervisory authority, and it also act as a mechanism for the supervisory authority to monitor the quality of loans in the books of banks. 4.1 Who rates loan? All the interviewed banks admitted that they have a detailed written loan policy that functions as a set of guidelines for loan officers and banks management for making loan decisions. Among other things, the policy clearly specifies the maximum amounts and types of loans that each position and committee can approve and what signatures are required. The loan approval process is in fact hierarchically structured, and the number and levels of signature needed depend on the size of the loan, the type of customer and the associated level of risk. In general, smaller and less risky loan requires lower level of approval, and the approval level ranges from three to six

8 Out of the five banks that have participated in the study, three had a formal and systematic internal credit risk rating system in addition to the previous mentioned five-category loan classification scheme. All these three banks are branches of overseas banks. It is worth pointing out that although the local banks do not have a formal system with a set of rules empirically derived and tested to differentiate among other pass loans, many do, to a certain extent, differentiate among their various pass loans based on accumulated experience and knowledge they have of their customers and the market. The fact that banks charge different interest rates and offer different loan terms to different customers, based among other things on the perceived loan risk, provides clear evidence that they do indeed discriminate among their pass loans. The three banks that have a rating system are all branches of overseas banks, with regional head offices in Hong Kong. During the interview, the managers of these banks confirmed that the rating systems they are using were developed by their headquarters and were not locally engendered. The rating systems developed by the headquarters were first introduced in Hong Kong. But before they were adopted in Hong Kong, the systems were fine-tuned to reflect the specificities of the Hong Kong market. Once proven to work, the rating systems employed in Hong Kong were then adopted in Macao. Nevertheless, this only happened after some further adjustments were made to the systems to suit the uniqueness of the Macao market. 4.2 Number of grades on the scale For those branches of foreign banks with a credit rating system, their rating scale begins with 1, and the rating of 1 means the best quality (loan with lowest-risk) and higher ratings imply higher risk (see Table 2). Among the three banks, the minimum number of pass grades is three and the maximum five. For the banks own management, the last four grades are seen as an internal monitoring category. Thus two of the banks with three pass grades have a 7-point grade system while the third one with five pass grades has a 9-point classification system

9 When the above credit rating systems are compared with the loan classification scheme of the AMCM, we notice that they have similar names for the last four grades. For the three banks, the last four grades are grouped as monitoring category whereas for the AMCM, the last four grades are known as regulatory problem asset. Although loans classified under both the monitoring category and the regulatory problem asset are high-risk loans that require special monitoring, they do differ in their essence and application. First, there is no direct correspondence between the grades in the monitoring category and the regulatory problem assets. Second, they have administrative meanings that may be conceptually different. The regulatory problem loan is based on how long the loan principal and/or interest has been outstanding. The monitoring list, on the other hand, is used in special supervisory activities such as formal regular review and report of loan status. In many banks, it is used primarily as a tool for senior management to monitor and react to important development in the portfolio. The 7-point rating scale is slightly less precise than the 9-point rating scale. The bank with the 9-point grading, a more refined system, has its core operation focused mainly on commercial business customers and classifies itself more as an investment bank rather than a retail bank. This explanation is sufficient enough to justify the need for a more refined system that allows a more accurate classification of the existing and potential customers in line with their degree of risk. According to the interviewed banks, the lowest risk category would be equivalent to investment grade firms or a loan collateralised by cash. As indicated by those banks, most of their new loans belong to the higher-risk rating pass category, and with the limited number of pass grades in their systems, it is very likely that the bulk of new customers are assigned to a single category. 3 This suggests that despite having rating systems, the benefits of such systems are trivial given that most loans receive a rate equivalent to the pass category. 3 For the two banks with 7-point grades, most of their new customers would be assigned to grade

10 Table 2: Risk Structure for Banks with 9- and 7-Rating Systems Risk level Bank with 9 Grades Bank with 7 Grades Virtually no Risk 1 1 Low Risk 2 Moderate Risk 3 2 Acceptable Risk 4 Borderline 5 3 Other Assets Especially Mentioned (OAEM) 6 4 Substandard 7 5 Doubtful 8 6 Loss 9 7 None of the participating banks was in position to give the breakdown of new customers assigned to each one of the pass categories. However, they all reported that only very few of their customers were assigned to the best rating of 1. Regarding the rates assigned by these banks, they are by no mean directly comparable in terms of their creditworthiness. This is true even for two banks that have the same number of pass grades. The rationale for this is that each bank has its own approach to develop its rating system. Besides, they may consider different factors. And even if the factors were the same, it is very likely that the weights assigned to each factor may vary from one bank to another. Which factor is included in the rating and what weight is assigned to each factor vary according to a bank s customer base, staff expertise and business priority. When classifying a customer into a particular grade, banks will examine both quantitative and qualitative information. For the quantitative evaluation, most of the

11 banks have some sorts of financial model as the basic element in the loan assessment. Of all the quantitative factors, cash flow performance is the most crucial one, followed by loan-to-income ratio, operating performance and asset quality. Other important factors that banks will consider are the leverage ratio and the pro forma financial statement. When it comes to the assessment of qualitative aspects, there is no exception all the surveyed banks adopt the full expert-judgment system. The character of the loan applicant and his previous relationship with the bank are the two most important qualitative factors in the evaluation of a loan s applicant. The emphasis on these factors is justified by the fact that in Macao, the vast majority of companies do not have a proper accounting system. Therefore, the officials in all the banks interviewed reported that the exercise of human judgment, based on the know-how and experience of the bank staff, is fundamental to the assignment of the grades. Finally, rather than having a credit decision based on a two-dimensional rating system, where both borrowers and facilities are rated simultaneously, banks in Macao only assess the risk characteristics of the borrowers, but not the facilities. The former relates to the borrower as a legal entity, while the latter relates to a specific type of transaction and reflects the risk posed by individual exposures. In Macao, there are two situations when the bank would rate both the borrower and the transaction. First, when the borrower is new to the bank such as a new customer; the bank tries to ensure that the customer and his project are both viable. This is because the source of repayment for this specific customer may only come from the cash flow generated by the project proposed for financing. Second, when an existing borrower has a totally new project, which is not related to its current operations, that needs to be financed. Here, although the bank knows the customer, it will try to clarify whether the new endeavour is self-sustainable, the degree of risk it poses to the established line of business of the borrower and the borrower s ability to sustain in case of failure

12 4.3 Credit risk mitigation Given the information asymmetry between lenders and borrowers, where borrowers appear to know more about the true situation than lenders, borrowers are required to post in form of collateral that can be taken over by lenders should they default on the payment. All the participating banks reported that almost all of their business is fully backed by collaterals and guarantees. All of them pointed out that they are very keen on guarantees and regard them as a very important safety net, especially for business loans of large volume and high default risk. This shows that in the assessment of their customers, the banks are not only interested in their customers future creditworthiness, or otherwise the probability of default, but also the expected severity of loss in case of default and how to minimise it. Indeed, the collateral seems to be a very important factor for banks operating in Macao. A glimpse at their balance sheet reveals that for most of them, the total book value of collateral exceeds the book value of loans made. There are three popular forms of collateral that are requested by Macao banks, namely business-related, personal and third-party consigners. Obviously, in general, banks do not ask for all of them at the same time. However, there are situations in which it does happen. The reason can range from getting protection of exact extent of exposure to building several layers of safety net to ensure adequate protection. These layers of safety net that banks build around them allow them to go after the personal assets of the customer, and in case where he is not able to meet his obligation, somebody else will pay for it. With this approach, even if it may take longer time, banks are always able to collect their money back. The most common types of asset pledged as collaterals include real properties like residential or office flats, personal properties like automobiles and other forms of property such as inventory and account receivable. Before actually accepting the collaterals, banks will conduct an inspection and appraisal of the assets so as to determine their market value, to confirm the ownership and to know whether the assets have been pledged as collaterals to any lender before. To further safeguard

13 their position, according to some managers, it is a practice in Macao for banks to underprice the assets by 20% to 30% of their actual market value. 4.4 Loan review and its impact on loan s price The loan agreement does not end with the endorsement by a borrower and a bank. Indeed, it is just the beginning of a long and complex process that spans the life of a loan. The bank must monitor the loan on an on-going basis because the conditions under which the loan is made are constantly changing and will affect the borrower s financial condition and his ability to repay the loan (Rose 2002). Computerised systems are normally used to assist banks in the review process. For instance, such systems would automatically notify the loan officer whenever a customer has missed a payment or whenever the review period for a loan has come and prompt the officer to take an action. Individual banks have their own review periods. Usually, the riskier the loan is, the more frequent the review will be. The loan review allows banks to assess the financial strength of their borrowers and their prospects and at the same time an opportunity to calibrate the credit rating models. After the loan review, banks may change the credit rating of a customer and adjust the interest rate accordingly. The truth, however, is that the banks seldom modify the interest rate. They reckon that an increase in interest rate during difficult times may cause more harm not only to the customers but also to the banks themselves. Nevertheless, such a change in credit rating may actually be taken into consideration in pricing new contracts. In addition, the loan review is also used to identify loan concentration and to take measures to correct, if necessary. Consequently, the loan review is not just a tool for establishing banks loan-loss reserve, but also a tactical and strategic tool

14 5. Conclusion The need to anticipate a customer s failure is not new in the banking industry. However, the use of sophisticated models by financial institutions may make such predictions a relatively recent phenomenon. Our survey reveals some phenomena of banks adoption of credit rating tools in Macao. Large locally incorporated banks and branches of overseas banks follow a five-category loan classification system while the usage is largely for the computation of provisions for doubtful debts. For branches of overseas banks in Macao, formal and systematic credit rating systems are normally developed in their respective headquarters. Banks participating in our survey also possess two features. Firstly, none of the banks interviewed assign obligatory ratings to both the borrower and the facility of each loan. They all rate only the obligor. This makes it clear that the risk rating is designed to depict the risk of loss of each borrower rather than each facility. Finally, as banks obtain guarantees in nearly all transactions, it is not difficult to understand why banks produce ratings for the borrowers only. Indeed, in many cases, the book value of a collateral even exceeds that of a loan

15 References Crouhy, M., D. Galai, and R. Mark (2001), Prototype Risk Rating System, Journal of Banking and Finance, No. 25, English, W.B. and W. R. Nelson (1998), Bank Risk Rating of Business Loans, Board of Governors of the Federal Reserve System Working Paper, Washington, DC. Patricio, A.P. and A.P.I. Vong (2005), Credit Risk Assessment in the Macau Banking Sector, Euro Asia Journal of Management, Vol. 15, No. 2, December, Rose, P. S. (2002), Commercial Bank Management, McGraw-Hill. Sinkey, J. F. (2002), Commercial Bank Financial Management in the Financial Service Industry, Prentice Hall Inc. Treacy, W. F. and S. M. Carey (2000), Credit Risk Rating System at Large U.S. Banks, Journal of Banking and Finance, No. 24,