Analyzing FI Credit - A Primer - For beginner Credit Managers/Analysts on the FI Space and hopefully a refresher for seasoned specialists..

Analyzing FI Credit - A Primer

Introduction

Some would say that analyzing FI is an easier proposition than Corporates, given the disclosure requirements, tight regulations and most often than not, the implied Sovereign support that we assume.

The main difference that I have seen between corporate and FI analysis, is that a Corporate may die a slow death - slowly declining revenues/market share, bleeding bottom line, inability to meet WC requirements, increasing leverage etc. But an FI, mostly gets hit by a cardiac arrest.

One fine day, the assets just tumble, impacting its credit quality and market access and its end of the line. The endgame is much sudden and hence, as an analyst, we may not have an escape route to state that I had picked the early warning signals. So, instead of early warnings, for FIs, its all about forming an opinion if current lifestyle of the bank exposes it to a shock or not.

The write up uses source material from Moody's Rating Methodology on Banks wherever applicable. 

Basic Guidelines

Do not go to the numbers straight. We need to read and form an opinion as to what numbers would look like and then see if numbers say the same story that you have formed in your mind.

That story comes from understanding several parameters:

Type of the Bank.

Corporate Bank	Diversified or exposed to specific sectors like Construction/Real Estate? This may mean cheaper CASA base. Also, huge public sector deposits. This would mean better profitability. Highly correlated to larger economic swings in the Country.
Investment Bank	Large investment book on the balance sheet. How good is the asset quality here? What is the size of sub-investment grade as a % of equity? Quoted/Unquoted equities within investments? Real Estate holdings? Are there any investments in banking subsidiaries in other regions that may be risky (say, Turkey?)
Retail Bank	Stable funding mix in the form on retail deposits, which are not volatile to Market Sentiments. Better margins through aggressive pricing? But would find it hard to earn fee income, corporate deposits, syndications etc.
SME Bank	Now, this may be highly profitable given the higher spreads, but NPA may be higher. How is the economic situation evolving for SME sector?
Diversified Bank	That would be good. If its not dependent on a single line of business and is spread over multiple activities, that would be good.
Public/Private	Some countries like Bangladesh have a huge divide in terms of credit quality between private and public banks. Private are stronger, but less implied government support, vice versa for public. Even Turkey, there is a level of comfort for public sector banks. Private sector may be better run-in countries like India.
Tier	Is this a larger tier FI in the country, holding say more than 5% of system assets? In some countries, once you take out the large two banks, the rest would be small. We need to be cognizant of this disparity. Larger banks may have better equity base to withstand volatility. Once you move into smaller tiers, comfort should go lower.

Direction of the Economy

Growing	Is this genuine demand driven growth or due to any fiscal stimulus? Is that sustainable? Are there any Government driven initiatives to increase credit growth in the Country? Does this mean that bad credits are also getting booked? Is the rate of growth in line with rate of GDP growth.
Stable	How is the bank finding avenues for growing asset book? Is the growth higher than economic growth? Is it towards riskier asset classes?
Recessionary	A strong growth during a negative economic cycle may end up counterproductive as loans season. Growth during such times would result in higher NPAs later. Is the risk profile increasing for the asset base, with higher provisioning requirements, higher NPAs, lower profits?

Banking sector.

• Outlook: Read about Moody’s/S&P or even news report specifically on the banking sector of the Country to form an opinion on how the sector itself is performing. If there is a negative outlook, be it aligned to country rating or any specific parameters, we need to compare it against our obligor.
• Specific characteristics: Understand intricacies of the Banking sector in each region. The public/private sector divide in Bangladesh, the exceptionally low ADR in Pakistan representing lack of credit opportunities, the high FCY financing and large ADR numbers carried by Turkish banks, high ADRs in UAE banks etc.
• How is funding market evolving? Is the base rate getting higher in the market? Does that mean Government is trying to curtail economic activity?
• Is the Country’s banking sector too big, that many banks chasing fewer assets? UAE is one such example and we have weak underwriting standards.
• Presence and strength of the regulator - is the regulator considered independent and strong, like India, that chances of fraud or mismanagement is kept under check? Or it the institutional strength not that great?
• How about recent regulatory changes? Have they changed NPA recognition from 90 days to 180 days? This happened in Bangladesh. Have they allowed restructuring by just paying a small amount? Is the regulator forcing banks to lend above a threshold? Turkey recently had enforced an Asset Ratio that the banks had to lend up to a particular ratio, failing which they would be penalized. This is intended to boost credit growth in the economy, but does that mean bad credits are being booked when economy is in trouble? Is there any change in accounting standards?
• Attitude of Government to support its major banking entities. Will they act as lender of last resort?
• When you are working on a country renewal process, ensure that you do a peer analysis. Compare ratios to find weak links and focus on that. 

Finally, on the obligor

• Recent news items.
• Interviews of the CEOs, Corporate Banking head, Treasurer etc. for the direction of the Bank.
• Any regulatory breaches being commented on.
• Any upcoming issuances.
• Market reaction to recent issuances.
• Any acquisitions/mergers and resultant impact on credit quality. Will the asset quality weaken from such a merger?  

Analysis

Once we have the story ready, then we go into the analysis.

Start with an introductory paragraph on what we have read so far - For ex: DIB, one of the largest banks in UAE, is primarily a corporate bank with major exposure to GREs by virtue of its ownership (__% held by ICD), which also provides a stable funding base. An opening statement that shows the character of the obligor. Keep it brief. Also give a flavor of the size - The Bank has an asset base of __bn, supported by equity of __bn. 

Then let us go on to analyze various parameters - and that must look like a continuation to opening statement.

Always be mindful of the following diagram - this is the core (from Moody's). Asset quality, capital position and liquidity are all linked to each other.

Asset Quality: What are the main components?

·       Loans and advances - talk about NPA levels, has it gone up from historical? If it has historically remained high, then those are legacy problems. Recent increase would be recent bad loans, showing weak underwriting standard. 

·      How about stage 2 loans? Provisions including Stage 2.  Parameters for stage 2 classification? Is that in line with global standards?

·       Is the loan book concentrated or diversified? This could be exposure to top 10 customers or major industries. It may be geography as well. Is it a single market player or do they have presence in multiple geographies?

·       What about provision levels? Around 80% would be considered good.

o   If the provision levels are low, is it always bad? May be the bad loans are well collateralized requiring less provision. A Bank calculates provision levels based on regulation and if its extremely low, then may be there is a reason for it. But still, a higher provision levels acts as a buffer to further fluctuation in equity and we would like to see a higher number.

o   For ex. A Bank mainly focused on real estate assets may have bulk of its NPAs as collateralized and hence may keep lower provisions. But are the asset pries stable in the economy? Can the securities loss value too soon? See if you can find details on collateral against bad debts. If we add up this collateral along with provisions, does that cover NPA by 2.0x?

·       Is the Loan book growth in line with economy? Growth rate above 10% is considered risky.

·     Is the NPA growth in line with economy?  Are there any government driven schemes which are camouflaging the NPA levels (like our TESS)?

·     Write off strategy: Also, a low NPA may not always be good. For ex, if the bank has a habit of keeping high provisions and writing off every year, your NPA will always remain low. So, do not just focus on NPA. Always investigate provisions as a % of pre-impairment profit. Are they providing 50% of pre-impairment profit every year? That is not that good. Say 40%? Would be good at around 30%.

·    Investments - how good is the quality here? Where are they investing? Government securities mainly? So, the Government exposure in loans and advances plus government securities here, how much does that form as % of assets and equity? In some cases, this is so high, for ex. NBE and Banque Misr and some Pakistani banks, the risk becomes equal to that of the sovereign. If this is primarily an investment bank, it may be carrying a trading book and if so, this risk would require in-depth analysis.

·     Real Estate - you sometime see this. May not be a large number, but enough to make trouble. I remember Sharjah Islamic Bank had such an issue. This plus real estate exposure in loans and advances, how exposed is the bank to Real Estate?

Capital Adequacy: This is not just about CAR.

·       Talk about components of equity - do they depend a lot on Tier II instruments? In some economies like Bangladesh, Tier II subordinated bonds are removed from CAR computation, one portion at a time, as it approaches maturity. This is also exposed to market sentiments. When things go wrong and the time when they need equity badly, that is when it may find it hard to issue new Tier II notes.

·     Overall, does the CAR has good buffer over minimum requirement? If you feel that provision levels are low by 20%, take 20% of NPA and deduct it from equity. Now divide that with RWA (you may find that in the annual reports) - what does the CAR look like now?

·    Understand how Capital is linked to Asset Quality - they together define solvency of the bank (along with profitability below).

·    Increase in NPA = higher impairment = lower profits = lower equity = harder to raise funds in the market = stressed liquidity = weak credit perception = deposit withdrawals = run on the bank. So, capital should be strong enough to manage a good jump in NPAs.

·    Ownership profile - do we have a strong shareholder in the backend who is willing and more importantly able to infuse equity? For ex. Turkish state-owned banks, Government is willing and was also able to infuse equity into the larger banks recently. Same may not apply in case of Bangladeshi or Bahraini banks.

·       Just find equity/total assets as if you are doing it for a corporate. Compare it with couple of peers. Is this bank keeping lower level of equity than required? This helps avoid impact of RWAs in CAR ratio. This ratio should be at least 10%. 

Profitability: The Bank needs to make Money.

·       This is linked to Solvency risk. The Bank needs to make money. It must lend higher and manage cost of its deposits and wholesale borrowing. What are the instruments used for funding - are they costly?

·       What is the Net Interest Margin? Compare it to major peers. Are they doing better?

·       Are they forced to take higher provision levels?

·       What is the ROAA? Did they make a good 1.5% or just a low 0.5%? Low profitability impacts solvency as well.

·       Check for volatility. Has it been fluctuating over the years? That may mean that the Bank is operating in volatile operations like traded investments or have weaker underwriting standards.

Liquidity: ADR is key.

§  Banks are inherently exposed to liquidity risk as the business is to borrow short term and lend long term. A loss of market confidence can impact funding and thereby liquidity.

§  What is a comfortable ADR level? May be 80%? What does it mean if its more than 100%? It means it has lend out more than its deposit base. So, if it must make one additional loan, it will have to borrow. Also, if a major depositor liquidates the account, it may have to depend on a loan settlement or fresh borrowing to fund the same.

§  But higher ADR may not always be bad. If this additional wholesale funding over deposits is coming from a stable source. For ex, repo transactions, short term commercial papers to retail investors, which are not that volatile to market sentiment. Sometimes borrowings under a government window. f you have a stable source of funding, then its not that bad to grow beyond your deposit base if good credit is available.

§  Also, look for liquid assets on balance sheet. Your cash, government securities, held with central bank etc. How much is it as a portion of assets? Say 15%? That would be good. That can meet contingencies to a large extent.

§  Also, your regulatory ratios like LCR - what does it mean? The liquid assets held to cover net cash outflows projected over the 30 days. Also, NSFR - your ratio of stable source of funding vs. required stable source of funding. View it this way - the level of core deposits, long term debt and equity held by the bank (i.e., stable source of funding) vs. its long term and illiquid assets like loans, illiquid investments etc. That is required stable source of funding to match these assets against actual long term funding source it has.

§  Another major metrics of liquidity is the deposit mix. Do not overlook this. May be the deposit mix is mostly long-term deposit, and that too from institutional investors. That means its expensive and institutional investors have strong market and credit perceptions. If they feel that risk is rising, they will just move the deposit, impacting liquidity at the very outset of tough times. If the mix is more retail, they are least bothered about Moody’s downgrades. Also, CASA is good cheap stable source of funding.

§  Following is the credit sensitivity on major financing streams. Which one is your bank dependent on?

o   Money Market funds - very volatile, linked to credit confidence.

o   Interbank funding.

o   Foreign Investors - would be withdrawing funds at the first weak signal.

o   Domestic local currency investors.

o   Secured bond holders.

o   Retail investors.

§  Same way, credit sensitivity of deposit base as follows:

o   CASA - considered stable at a portfolio level.

o   Retail savings accounts.

o   Corporate deposits.

o   Sophisticated investors.

§  Funding maturity gaps - is there a large shortfall in the short-term bucket whereby it does not hold any liquid assets against short term maturities? Will it have to liquidate long term assets at a loss to meet ST liabilities?

§  Market access of the bank - how good is it? Can they quickly access market to raise some funds? Is the funding cost of the Bank higher than peers? That means it is not viewed favorably in the market and must pay higher cost.

§  FCY liquidity

o   Limited disclosure and tough to assess but keep your eyes open towards it. FCY liquidity risk arises when the bank take financing in one currency but majorly lends in other.  If the country goes through an FX shortage, like Egypt, Bank will find it hard to access the same.

o   Available FCY liquid assets - is that sufficient to meet market sensitive short term external debt?

o   But this FC liquidity, is it heavily reliant on Central Bank, to get that dollars to repay the debt?

o   For ex. Turkish banks had 84bn of external ST debt, out of 135bn of total external debt. They had 82bn of FC liquidity. But these FC liquidities was in the form of placements at CBRT, mainly in the form of FC swaps.

o   But CBRT had negative FX position net of all banks’ FC claims. So, Country’s FX position would come under stress if Bank’s are forced to access CBRT for FC to pay off debt rather than refinancing it in the market.

o   Rollover Rate - is the sector efficiently refinancing the debt?

Give a closing remark based on the asset quality, supporting capital position, the liquidity and profit-making ability.

Once you have completed the above, only then read the Moody’s/Fitch report. Then as you find appropriate details, add it to the respective sections above. Its like finishing a picture. Rough sketch is ready above - now add the finer details. It will look great.

Other Points:

Covenants:

§  If it's a bilateral level financing (and not a market issuance) and we have an option to add covenants, please do so. If we put a covenant in place, say on NPA ratio of say 6%, if the NPA suddenly goes from 4% to 8%, our loan becomes immediately callable. We can accelerate repayment of our facility. 

§  Covenants can be on CAR, Debt/Equity, minimum equity levels, NPA, Coverage, cost to income ratio or as applicable.

§  Keep the covenant levels in line with strategy and the peer average. If the sector works at a 4% NPA, that can be a covenant.

§  Pricing can and should be linked to ratings. If there is a rating downgrade, pricing should be jacked up.

Collateral:

§  If that bank is mid sized, do not go for clean limits. Ask for collateral backed lending. That can be cash and most often, sukuk backed. These are like repo transactions. Make sure that you define the margin call levels, collateral margin levels and ensure CAD has instructions to close out, in case of fall in collateral value not supported by a margin call.