Credit Rating System in Banks - An Introduction
A K Srivastava, Acs, Practising Company Secretary, Jamshedpur.
This article discusses the basic aspects of the need for and the parameters involved in the system of rating
credit worthiness of borrowers by commercial banks centered on the system in vogue in PSU Banks with
some peeks into the system of Credit Risk Analysis (CRA) in banks in private sector.
Introduction
The system of rating is changing fast as the banks have to incorporate the emerging issues by assigning some
value to them by a process of continuous amendments in parameters involved and their exclusion at other
time. The Credit Risk analysis is an important inbuilt system in every bank and provides a basis for objective
decision making relating to limit enhancement, financing investment in new business, mergers and
acquisitions etc. Borrowers having better rating are in position to bargain for better interest rates in a volatile
interest situation much below the PLR of the bank sometimes and also are favoured customers of the bank. It
should be noted that the basic parameters are almost similar in all banks - both PSU and private sector banks
with some variations. However, the PSU banks have mostly a decentralized system of ratings as compared to
banks operating in private sector, both having their own advantages and limitations.
Any model, more so financial model, is a time dependent entity. This entity is always a combination of
quantifiable and unquantifiable parts commonly referred to as objective and subjective elements in
assessment. The degree of subjectivity/ objectivity in a particular scenario is dependent on the level of
mathematical technique developed and employed. Both these subjective and objective parameters of
assessment may remain in all types of risk rating with different degrees of emphasis depending upon the time
and peculiarity of situation. The degree of subjective assessment brings into focus the judgmental aspect
which recognizes ultimately the human capabilities which is a combination of qualification, skill, experience
and attitude.
The subjectivity of course swings from one extreme to the other. The appraiser at the operating level (mostly
in decentralized systems) measures the risk or identifies the gaps based on his own assessment. The extent of
risk and the human capability to identify that risk becomes central to this measurement process which may be
of four types :




Future risk unlimited and human capability unlimited ;
Future risk unlimited and human capability limited ;
Future risk limited and human capability unlimited ;
Future risk limited and human capability limited.
OVERALL RATING ASSESSMENt
The overall rating of a borrower is the aggregate of various factors suitably weighted. These parameters may
be classified under the following four/five broad heads:
 Financial Risk
• Quantitative (Static) – Ratios;
• Quantitative (Dynamic) – Historical Comparison;
• Quantitative (Dynamic) – Industry Comparison;
• Qualitative Factors – Negative parameters.




Business Risk
Industry Risk
Management Risk
Conduct of Account.
RATING SCALE
Rating Scale may have 6 to 9 points. Currently one PSU banks rates the accounts on an 8-point scale from B1
to B8 and BTL1 to BTL8 pertaining to working capital and term loan respectively. The bank rating scale
corresponds to the following marks (out of a maximum score of 100) :
B1/BTL1>= 90 ;
B5/BTL>=4
5;
B2/BTL2>= 75 ;
B6/BTL>=3
5;
B3/BTL3>= 65 ;
B7/BTL>=2
5;
B4/BTL4>= 50 ;
B8/BTL< 25
;
B4/BTL4 is currently the hurdle rate of new connections and enhancements in case of existing accounts in
terms of their loan policy.
Another variation of the above in a private sector bank may be presented as below:SME1>= 85.01 and
above ;
SME5>= 57.01 to <=
62.00 ;
SME2>= 75.01 to >=
85.00 ;
SME6>= 51.01 to >=
57.00 ;
SME3>= 69.01 to >=
75.00 ;
SME7>= 45.01 to >=
51.00 ;
SME4>= 62.01 to >=
69.00 ;
SME8<= 45.00.
STRUCTURE OF CREDIT RISK ANALYSIS
The CRA model may be divided into four/five broad heads assigning total value of 100 or more depending
upon the system of assigning values prevalent in a bank by aggregating unit values assigned to individual
parameters under each head. Briefly the structure may unfold as per the following:
Financial Risk
The risk under this segment are analyzed as follows:
Static Ratios
1. Current Ratio (CA/CL)
Max.1.33; Min. 1
2. TOL/TNW
<=1.5 to Max. of <=
3
3. PAT/ Net Sales (%)
>=7.5 to Min. of
>=2.5
4. PBDIT/Interest
>=3.5 to Min. of
<=1.5
5. Return on Capital Employed ROCE (%)
>=15.50 to Min. of >=7
6. INV/Net Sales +
Receivables/
<=90 days to Max.
Gross Sales
<=210
7. Trends in Performance
-
[In case of trends in performance of the borrower the four years trends of the basic four ratios viz., Current
Ratio, TOL/TNW, PAT/Net Sales and Return on Capital Employed are compared. Continuous improvement
for three years refers to the maximum score assigned.]
Future Prospects
Parameter
% Achievement
Projected Profitability
(PAT/ Net Sales)
6% or more up to
Minimum of 3%
Non-achievement of the above projection below 80% of the projection will square off the score to zero in this
segment.
Risk Mitigation- Collateral Security/ Financial Standing of the Borrower
In case corporate financing a combination of securities and guarantees are involved to secure the loan granted
to the borrower by Banks. Collateral Security or Financial Standing of the Borrower is measured under two
broad headings:
i. Tangible Collateral – This includes,
 Liquid Collateral Security; and Mortgage of Property.
The realizable value of the security is the bench mark for evaluation of such securities for the purpose of
scoring marks. Realizable value of Collateral Security at more than 40% of the total exposure secures the
highest marks assigned to it. The minimum range is more than 5% of the total exposure to secure at least the
minimum marks out of maximum provided in this segment.
ii. Guarantees : – There may be a combination of guarantees. The values assigned to different forms of
guarantees may be as follows :
Type of Guarantee
Score
1. Government of India Guarantee
3
2. State Government Guarantee
0
3. Personal Guarantee/Third Party
Guarantee
1
4. Corporate Guarantees (of Limited 3
Companies)
5. A Combination of Guarantees
6
Max
6
The corporate guarantees given by a limited company may be rated as per the following : -
External
Rating
Agency
CRA
Rating of
Company
furnishing
Guarantee
AND
Additionally
TNW of the
Guaranteeing
Company as %
of total exposure
of Borrower
Score
AAA
B1/B2
>=300%
3
AA+
B3
>=200%<300
2
AA
B4
>=100%<200%
1
The corporate guarantor/borrower is listed company and it issues Bonds/ CPs etc. which are rated or get
regularly rated by the established rating agencies, such ratings reflect the financial strength of not only that
particular issue but also that of issuer Company itself to a great measure. These ratings give credit
enhancement comfort and marks can be awarded to such companies depending on the ratings of their issues
as under:
CRISIL
ICRA
SCORE
AAA
LAAA
6
AA+
LAA+
5
AA
LAA
4
AA-
LAA-
3
A+
LA+
2
A
LA
1
Note : - Score assigned to explain the weightage of parameters generally.
It should be noted that total score awarded under this segment of Financial Risk Analysis is maximum of
50% of the aggregate total assumed score of 100 taken as a base. This is a major shift as rest 50% or more
score is assigned to subjective parameters. Earlier the financial parameters were assigned the total score.
Subjective parameters were analyzed to decide whether to finance or not in a sector or to a particular
borrower on the basis of specific information available to the bank or procured by the appraiser.
Business Risk
The risk under this segment may be analyzed by taking into consideration the following parameters with
respective value assigned to them as per the practice in vogue in the system. The parameters may be all
inclusive as listed below:






Technology
Capacity Utilization or Break Even Point
Compliance with Environment Regulation
User/Product Profile
Consistency in Quality
Distribution Network
Consistency in Cash Flows.
The borrower operating 30% above its Break Even Point can secure the highest score awarded for that
parameter which is high standard set in a PSU bank and is unworkable for many sectors. Non-compliance
with the environment laws will give exit option to the bank and compliance under environment laws is
mandatory. This is a welcome measure but the ground reality is different. In many States the implementation
of environment laws are in total disarray. Unqualified and persons of dubious background have been made
State Pollution Control Board Chairmen and members. Procuring a certificate from the State Pollution
Control Boards without even partially complying under the conditions prescribed is not unknown.
Industry Risk
Many banks (especially banks in the private sector) have a centralized system of Industry Risk Rating which
is desirable as at branch level the banks may not be having qualified and skilled personnel to analyze the
industry risk. In centralized system the bank has its specialized team based at its head office where the skilled
personnel are continuously analyzing and rating the industry sectors and therefore, personnel at branch level
have no difficulty in deciding whether to grant a loan or not and also the terms and conditions (severe or
lenient) in a particular industry sector as they have readymade ratings of various sectors generated out of
their own internal data base.
This system may include the following parameters : (i) Competition ; (ii) Cyclicality/Industry Outlook ; (iii)
Regulatory Risk and (iv) Contemporary issues like WTO.
One of the most important risks relating to industry is cyclicality which refers to long term prospect of
industry in the background of risk of obsolescence, product replacement, consumer orientation etc.
Regulatory risk refers to new laws enacted by Government necessitated by environmental, economic or other
considerations.
Management Risk
The following parameters may be considered by the bank in evaluation of the existing borrower:








Integrity/Corporate Governance
Track Record
Managerial Competence/Commitment
Expertise
Structure and Systems
Experience in the industry
Credibility – Ability to meet sales projection
Credibility – Ability to meet profit (PAT) projection
Payment Record
 Strategic Initiative
 Length of Relationship with the bank.
In the case of a borrower which is a proprietary or partnership entity the term integrity refers mainly to the
reputation of the firm in the market and the integrity of proprietors and partners.
The other term namely corporate governance is applicable to all limited companies. Even though the term
corporate governance broadly refers to good corporate practices, it is not synonymous to the concept of
corporate governance enunciated in the Companies Act, 1956 or clause 49 of the listing agreement at present.
However, the terms Independent Directors and Audit Committees are fast gaining their familiarity in the
Banking sector and it will be no surprise if banks adopt the concept of Corporate Governance in future as it is
understood and implemented in today’s corporate world.
Some of parameters of Management risk may be evaluated under Conduct of Accounts.
Track record is another important parameter in this segment as the borrower having no irregularity in the
account i.e., no overdrawing, no LC devolvement etc. are considered very favourably by the banks for
granting working capital enhancements, new loans for setting up new line of business, mergers/takeovers,
investments in plant & machinery for capacity increase, etc.
The above system is used by banks with some variation here and there but almost uniformily. The system is
applicable to borrowers enjoying both Working Capital limit and Term Loan facilities. In case of borrower
enjoying both working capital and term loan facility a variation may be added by replacing the Return on
Capital Employed (ROCE%) and (Inventory + Receivables)/Net Sales parameter with Debt Service
Coverage Ratio (DSCR) for all loans in the financial risk segment.
In case of only term loan or in case of a new loan the following financial parameters are generally evaluated
with parameters in business etc. segments remaining unchanged :




Debt/Equity Ratio
TOL/TNW (Total outside liability/Total Net Worth)
Gross average DSCR (Debt Service Coverage Ratio) for the project
Gross average DSCR (Debt Service Coverage Ratio) for all loans
Terms of Repayment.
* DSCR = PBDI/Loan Installment + Interest.
Repayment over a period of more than 5 years is considered risker and is assigned low weightage.
QUALITATIVE FACTORS
They are considered negative factor as the total score may be reduced if the negative parameters are more
than a reasonable percentage of Total Net Worth and the probability of invocation is positive. The negative
parameters include the following: Contingent Liability
– Disputed Tax Liabilities and other legal liabilities /pending civil suits.
– Claims against company not acknowledged as debt
– Corporate Guarantees given without bank’s permission
 Auditors qualifying remark ; and
 Accounting Policies – Includes - Inventory Valuation, Depreciation, Capitalization, revaluation,
exchange fluctuation, etc.
The aggregate value under the above parameters is taken from the Audited Balance Sheet and is assessed on
the basis of percentage of probability of invocation assigned to them. An assessed value of more than 10 %
of the total net worth may be assigned a higher negative score which will finally be deducted from the total
score gained by the borrower under the system of rating explained above.
FOOTNOTES:
e-mail :akshrivastava@sify.com