(Editor's notes: These criteria have been superseded by the article titled "Criteria | Financial Institutions | Banks: Rating Banks," published on March 18, 2004)

Bank Ratings Methodology

Rating Analysis Methodology Profile

Credit analysis of a bank includes a wide range of quantifiable and nonquantifiable factors. The weight given each in the analysis of a particular institution will vary, depending on its competitive position within its specific sector, the characteristics and the risk profile of the sector itself, and the overall regulatory environment. Thus, there is no standard group of ratios that set minimum requirements for each rating category. Taiwan Ratings Corporation (TRC) takes the following key areas into consideration when rating a bank:

INDUSTRY RISK

The industry risk category contains many elements, and for each type of financial institution there will be both positive and negative factors. While it is difficult to say which factors will outweigh others in any one category, generally Taiwan Ratings Corporation gauges the dynamics of the financial services industry and to what extent those dynamics lead to more or less risk from the debtholder's or counterparty's point of view. Following is a list of considerations for the industry risk category.

Structure.

• The basic structure of the banking system, which includes the number and relative sizes of institutions and restrictions on geographic or product expansion;
• Proportion of finance in the economy that is intermediated through the banks; nonbank competitors in the market and the extent to which they pose a serious challenge to the banks in their role as intermediary in the economy;
• Depth of publicly traded capital markets and the trends in this area;
• Dynamics of interindustry and intraindustry competition, barriers to entry, expectation of change, and degree of disintermediation in industry;
• Consolidation trends in banking system, the number of banks and branches in relation to the population, and impediments such as labor laws that negatively impact the banks' ability to reduce overheads;
• Strategic stakes in industrial companies and types of benefits and risks posed by these holdings;
• Extent to which political or other interests are able to influence the decisionmaking process at the bank;
• Quality and transparency of accounting and reporting systems and the quality of external auditing; and
• Strength and efficiency of country's legal system

Ownership structure of banks

• Degree of government ownership within the banking system, the extent to which government involvement in the system affects the competitive dynamics in the banking market; and
• Degree of ownership of banks by corporate or individuals and advantages and disadvantages of or dangers stemming from these relationships.

Market position and diversification

Market position:
Focuses on the evaluation of benefits or weakness stemming from institution's market position.

• Bank's market shares in key businesses and the size of these markets;
• Real advantages stemming from bank's market position (e.g. pricing power, funding base, quality of business etc.); and
• Vulnerability of market position.

Diversification:

• Analysis of diversity of a bank's business and benefits stemming from it; identification of any geographic or business concentrations;
• Diversity of products/business lines/customer base;
• Geographical spread of bank's business base;
• Economic diversity of bank's home market(s); and
• International diversification: size and extent to which this adds real franchise value.
  

Credit Risk
Looks at an institution's credit risk across the entire spectrum of the institution's activities (including loans, debt securities, equity investments, on- and off- balance-sheet counterparty exposure etc.)

• Structure of balance sheet, including relative proportion in different low credit risk assets (e.g. government bills or interbank deposits) compared with higher risk assets (e.g. loans or equities);
• Fixed-income securities (breakdown by type, largest positions, and market value and maturity structure);
• Equity securities (breakdown by economic sector, largest exposures, proportion of investment portfolio relating to previous underwriting positions, investment strategy, book value compared with market value);
• Credit portfolio broken down by maturity, loan type, collateral, customer base, economic sector, size, currency, and country;
• Concentrations of credit risk, such as large exposures to specific industries, markets, and individual borrowers, or in specific loan types;
• Problem loans: large problem-credit exposures, levels in and changes of nonperforming assets, past-due loans, restructured loans, and other problem-asset categories and expected future trends;
• Loan loss reserves, broken down by type, such as general and specific, reserves against on- and off-balance sheet exposures, taxed and untaxed;
• Reconciliation of each type of loan loss reserve over the past five years, showing new provisions, liquidations of provisions, charge-offs, and recoveries; and
• Reserving policy and adequacy

Market Risk
Level of market risk over the entire range of financial institution's activities, whether on- or off-balance sheet, e.g., in its asset and liability structure, trading activities, securities underwriting business, etc. Management's strategy and general risk appetite in these areas.

Structural risks

• Management's philosophy regarding asset and liability management and balance-sheet structure;
• Levels of interest rate, foreign exchange, equity risks in the balance sheet;
• Role of the treasury department and objectives and risk appetite;
• Reasons for structural risk: legal restrictions, regulatory requirements, limitations of local funding or hedging markets, or position taking;
• Use of non-cash market instruments, such as futures, forwards, and swaps; and
• Past and future position taking and balance sheet flexibility.

Trading risk

• Description of current organization
• Trading strategy on group basis and by individual products
• Review of historic trading activities by products and market, including size of positions, volatility of net revenues, and profitability. Proportion of revenues from sales, jobbing, arbitrage, and directional view. Liquidity of markets in which the banks deals;
• Perceived market strengths and weaknesses; market position and appetite for position taking;
• Future products and market expansion plans; and
• Breakdown of products by currency, credit quality, volume and maturity.

Funding and Liquidity
Represent the evaluation of the bank's sources of funds and factors influencing its liquidity position.

• Composition of the bank's funding (core retail compared with other retail, semi-professional, and professional markets);
• Diversity of funding sources, such as deposits broken down by geography and size, access to and importance in local and national capital and money markets;
• Flow of funds (net deposit flows, deposit maturates, stability of funding);
• Asset liquidity, which includes short-term deposits and securities, long-term marketable securities, extent of pledged assets, ability to sell or securitize loans, liquidity facilities at the central bank, and other sources of asset liquidity;
• Management's philosophy with regard to liquidity as well as liquidity planning.

Capitalization
Analytical emphasis is on capital that provides a cushion for the bank on a going-concern basis. Thus, Taiwan Ratings Corporation's perception of a bank's capital position may differ from that of a regulator, which accepts, as capital, instruments that provide a cushion for depositors only in the case of liquidation. Regulatory capital remains an important measure, however, as it influences the actions of bank management and the regulators.

• Capital composition. Quality of capital: levels of common equity, preferred stock, convertibles, subordinate debt, perpetual debt, minority interests, goodwill and other intangibles, revalued assets, unrealized capital gains, loan loss reserves in excess of probable losses, and other types of quasi-equity. If a holding company structure is involved, level of double leverage;
• Comparison of capital with perceived level of risk in institution's business: Bank for International Settlements (BIS) risk-weighted assets adjusted for high credit risk assets (e.g. equities or specific types of lending) or market-risk activities;
• Bank's capital position with respect to domestic capital requirements and the requirements of the BIS;
• Dividend layout ratio, internal growth rate of capital
• Absolute size of bank's capital base and its ability to absorb extraordinary, unexpected losses that could arise, given the bank's business mix;
• Ability to tap external sources of capital and long-term funding. Bank's market capitalization compared with book value; and
• Management's philosophy regarding risk asset and loan leveraging of its capital base and capital projections.

Earnings
Key considerations are earnings levels, trends, and stability; the basic long-term earnings power of the company.

• Net interest income: margin trends and ability to maintain volume;
• Noninterest income: diversity and sustainability of other income sources and growth potential;
• Operating expenses: level and trend of overhead relative to the company's business mix and distribution network, degree of automation in comparison to peers', ability of earnings to meet current and future needs;
• Loan loss provision (current level, past volatility, and ability to absorb future requirements);
• Net operating income analysis (level and trend);
• Quality of earnings: Proportion of income recognized as core earnings, proportion of earnings from trading activities, ability to price risk into various products, and actual return on the perceived risk in the book;
• Impact of extraordinary gains and/or charges;
• Tax position: management's philosophy toward tax payment position and cushion, including historical and future use of net operating loss carrybacks and carryforwards, other strategies that affect tax position;
• Impact of inflation on earnings, return on equity versus the reporting period's inflation rate;
• Earnings outlook, year-to-date budget versus actual, projections for following year and medium-term plan; and
• Quality of bank's accounting practices.

Risk Management
Looks at the bank's systems for managing all types of risk: credit, treasury, trading, liquidity etc. In these areas, not only are the rules and guidelines on how risks are to be managed important, but also the degree to which the rules and guidelines are actually enforced at all levels.

Credit risk

• Underwriting criteria, the approval process for different types of products or customer groups (for example, fixed-income securities, investment or trading equities, mortgage loans, customer loans, and corporate loans), delegation of approval authorities down through the organization and collateral valuation;
• Monitoring of credit exposure: control at time of loan disbursement, review function, internal rating system, delegation of responsibility for identifying potential problem exposures, and the role of the audit department; and
• Problem assets: responsibility for follow-up, collections, aggressiveness with which problem credits are handled, and collateral foreclosure policies.

Market risk

• Senior management's understanding of market-risk issues and its involvement in risk management decisions;
• Membership of the asset-liability committee (ALCO) or other decision-making body, reports filed with ALCO, how its decisions interact with daily risk management, limits set by ALCO for different types of risks;
• Information technology: description of software used to monitor structural and trading risks, adequacy of computer systems in relation to the current and projected levels of market risk inherent in the bank's business as well as management's risk appetite;
• Strategy regarding intentional position-taking, limits, and authorities required for breaching limits;
• How traders and desk heads monitor positions and how the system interacts with the overall risk management system;
• Hedging strategies;
• Description of method(s) by which market risk is measured and assumptions used;
• Stress testing: frequency and assumptions, flexibility;
• Back office and operations: organization vis-a-vis the trading floor, valuation of positions, and disaster recovery;
• Audit function;
• Accounting policies; and
• Track record versus intended risk exposure. Major errors over the past five years in position-taking, hedging, and accounting.

Financial flexibility
Evaluates a bank's ability to meet unexpected demands on capital and earnings.

• Ability to assess various funding markets and raise capital from public or private sources, generally and in a difficult environment;
• Internal reserves that could be used to cover unexpected losses;
• Franchise value of discrete business, assets where the market value is significantly greater than the book value, ability to sell, likely value in stressed situations; and
• Likelihood of support from governmental or private shareholders