Professional Documents
Culture Documents
RATING METHODOLOGY
Bank Credit Risk In Emerging Markets
(An analytical framework)
1. Introduction
In April 1999, we published a Rating Methodology study entitled “Bank Credit Risk: An
Rating Methodology
Analytical Framework for Banks in Developed Markets”. That study outlines the conceptual basis of
our approach to bank analysis worldwide. The purpose of this study is to highlight issues which
are of particular importance when analysing the credit quality of banks in emerging markets
around the world.
continued on page 3
Author Editor Production Associates
Andrew Cunningham Giles O’Flynn Alba Ruiz, Susan Heckman
© Copyright 1999 by Moody’s Investors Service, Inc., 99 Church Street, New York, New York 10007. All rights reserved. ALL INFORMATION CONTAINED HEREIN IS
COPYRIGHTED IN THE NAME OF MOODY’S INVESTORS SERVICE, INC. (“MOODY’S”), AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE
REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR
ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR
WRITTEN CONSENT. All information contained herein is obtained by MOODY’S from sources believed by it to be accurate and reliable. Because of the possibility of
human or mechanical error as well as other factors, however, such information is provided “as is” without warranty of any kind and MOODY’S, in particular, makes no
representation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitness for any particular purpose of any such information.
Under no circumstances shall MOODY’S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to,
any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY’S or any of its directors, officers, employees or agents in
connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct,
indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY’S is advised in advance of the
possibility of such damages, resulting from the use of or inability to use, any such information. The credit ratings, if any, constituting part of the information contained
herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO
WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF
ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other
opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must
accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may
consider purchasing, holding or selling. Pursuant to Section 17(b) of the Securities Act of 1933, MOODY’S hereby discloses that most issuers of debt securities (including
corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MOODY’S have, prior to assignment of any rating, agreed to pay to
MOODY’S for appraisal and rating services rendered by it fees ranging from $1,000 to $1,500,000. PRINTED IN U.S.A.
2. A Word On Semantics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5
4.2 The Relationship Between Country Ceilings And Government Bond Ratings . . . . . . . . . . . . . . . . . . . . . . . . .9
4.3 Why Offshore Banks Can Be Rated Higher Than The Domestic Country Ceiling . . . . . . . . . . . . . . . . . . . . . 11
5.3 The Strength Of Capital And Provisions Is A More Important Element In The Analysis
Of Emerging Market Banks Than Is The Case With Banks In Developed Markets . . . . . . . . . . . . . . . . . . . . 13
5.4 In Emerging Markets, It Is More Frequently The Case That Bond And Deposit Ratings
Are Either Enhanced By The Likelihood That A Bank Could Be Supported In A Crisis,
Or Constrained By The Limitations Of A Country Ceiling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
7.2 Trends In Capital Markets, Disintermediation And Structure Of The Banking System . . . . . . . . . . . . . . . . . . . . . . 16
7.5 Transparency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
(Continued)
9.1 Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2. A Word On Semantics
Moody’s does not have a definition of what constitutes an “emerging market” or an “emerging market
bank”. We think it is unlikely that anyone could arrive at a consistently defensible definition. Emerging
banks fill various points on a continuum which runs from the strongest and most sophisticated banks
operating in the strongest and most developed economies, to the weakest and most simple banks in the
weakest and least developed economies. A single bank may display “developed market” characteristics in
some areas of its operations while being unsophisticated in others. More importantly, we just don’t think
the quality of our analysis would be enhanced by spending time trying to devise a definition. You will
therefore see references in Moody’s reports to emerging markets, developing economies, transitional
economies and so on. We do however, recognise that definitions do sometimes have to be employed sim-
ply in order to ensure a consistent processing of data. So for example the tables in Section 3 employ defin-
itions of emerging market economies employed by the IMF.
These trends have contradictory implications for the ratings assigned to banks. As financial markets
develop, opportunities increase for banks to diversify and enhance their earnings through new services and
products. On the other hand, over the medium term, their earning power will be challenged by competi-
tion from new players. The net effect of these two trends has to be considered on a case by case basis, but
in general terms we believe that banks are more likely to prosper in a well-developed and predictable
financial market which enables diversification of risk and of earning streams, rather than in a narrow and
immature market albeit one dominated by banks. As financial markets mature, it becomes easier for banks
to be assigned higher financial strength ratings.1
1 The development of financial markets brings risks as well as opportunities. Just as in developed markets, non-banking financial services (especially
securities trading and other investment banking businesses) contain substantially higher risks of losses and of earnings volatility, and this will be reflected in
our analysis of a bank that is engaged in these activities, be it in New York or Kuala Lumpur.
The debt and deposit ratings measure, a) the probability that the bank will default on its debt obliga-
tions over their life and b) the expected monetary loss should such a default occur. In contrast, the FSRs,
which were introduced in 1994, measure the bank’s stand alone financial strength without reference to
either sovereign transfer risk or implicit or explicit support from third parties. The FSRs should be seen as
a sub-set of the debt and deposit ratings. They are not a substitute for them.
Moody’s ratings are globally comparable …the best bank in each market does not
receive an A rating for financial strength.
FSRs often receive more attention in the emerging market investor community than debt/deposit rat-
ings. This increased attention is usually the result of most or all of the banks in a country being con-
strained by a country ceiling (so the intrinsically strong banks receive the same deposit ratings as intrinsi-
cally weak banks) or in a country where it is very likely that all banks would be supported in a crisis (so
intrinsically weak banks are pulled up to the country ceiling and receive ratings similar to those assigned
to strong banks). It should be remembered that FSRs can never substitute for debt/deposit ratings – they
measure two different things.
So for example, if an investor needs to compare the repayment ability of several banks and finds that
they have identical deposit ratings but different FSRs, the investor cannot use the FSRs to identify the
bank with the strongest repayment ability. If their deposit ratings are the same, that means that their
repayment ability is the same. But other investors – whose priority is not repayment ability – may wish to
make a distinction between the banks. To the extent that they wish to distinguish the banks by intrinsic
financial strength, FSRs will enable them to do so. Where country risk has to be accepted if a transaction
is to be completed the most acceptable counterparty may be the bank with the highest financial strength.
Moody’s ratings are globally comparable and one result is that banks in emerging markets tend to have
lower ratings than those in developed markets. The best bank in each market does not receive an A rating
for financial strength. It can be the case– and frequently is – that the best banks in a country may be rated
no higher than D or D+ for financial strength. It is particularly difficult for banks whose business is based
in an unstable economic and financial environment to be assigned financial strength ratings at the higher
end of the scale.
4.2 The Relationship Between Country Ceilings And Government Bond Ratings
It is generally the case that the lowest-risk issuer of foreign currency in any country is the government of
that country. This is due not only to the large holdings of foreign currency which a government com-
mands (foreign reserves, revenues from the export of state-owned commodities such as oil) but also to its
ability to appropriate foreign exchange from other sectors of the economy in order to discharge its own
obligations. The simplest case involves a government imposing transfer restrictions whereby private sector
entities may not transfer abroad foreign currency and/or are required to deposit foreign currency with the
national authorities. The central bank’s regulatory powers, the government’s legislative authority (and,
ultimately, the government’s monopoly of coercive force) enables it to do this.
This is not a theoretical point. When governments experience difficulties in discharging their own for-
eign obligations they do in practice seek to alleviate their own difficulties by restricting the transfer and use
of foreign currency by the private sector. And those measures tend to be effective. So when the Brazilian
4 There can be exceptions to this rating rationale: the main reason for the low local currency rating of Brazil is its possible inability to discharge its local
currency debts.
5 The argument that the government could always avoid a local currency default by printing more money is valid in theory but not in practice. In practice,
governments do not generally print more money to avoid a payment crisis. One reason is that if they did so, hyper-inflation might result, destroying the
whole economic fabric of their society. Governments often conclude that hyper-inflation is too high a price to pay.
The predictability of support is frequently predicated on a view that a certain bank is “too big to fail”.
Yet that idea encompasses a huge range of issues, and even the phrase itself is misconceived – the correct
terminology is “too big to be allowed to fail”. Governments almost always have the resources to save a bank,
so if a bank fails it is because the authorities have allowed it to do so. A full deconstruction of these issues
was published as a Moody’s Special Comment “Analysing the Predictability of Official Support for Troubled
Banks”, May 1997.6 On this occasion the following points should be highlighted:
• It is rare for creditors to lose money as a result of a bank failure. Throughout the world, financial
authorities strive to avoid the repercussions which would affect their whole economy if one of their
banks failed. We do not see this situation changing significantly any time soon, although regulators are
also conscious of the risks of moral hazard which arise from a strong predictability of support.
• Despite this, we do think it is important to understand exactly why a specific bank or group of banks
would likely be supported in a crisis. We are very unimpressed by bland statements such as “the gov-
ernment would never allow a bank in this market to fail”. The statement might be true, but we need to
understand why. For example, it might be based on the fact that the country has been led by weak gov-
ernments which cannot take unpopular action, such as allowing any constituency of voters to lose their
savings. If a strong government emerges, the possibility of allowing this to happen might increase.
• Timeliness of support is an important issue. Under Moody’s definition, a bank which misses a pay-
ment is in default even if all money due, and interest on missed interest, is eventually paid. As a result,
one of the questions we consider is whether the government has a pre-arranged mechanism in place
with which to support banks during a crisis, and whether the government has determined in advance
the criteria which it would use to extend such support (eg, automatic support for the biggest five
banks, but case-by-case decision for all the rest).
• A strong predictability of support does not necessarily enable a bank to be rated at the country ceiling.
Consider the hypothetical example of two banks, both equally likely to be supported in a crisis but one
of which is intrinsically weak and the other intrinsically strong. The fact that the weaker bank is more
likely to require support gives its repayment ability an element of uncertainty which does not exist for
the strong bank. The onset of a crisis might not be identified in time to get support in place; logistical
problems might arise (eg, managers and regulators not in situ to deal with the problem); allowing a
bank to fail could be required as part of a economic support package being offered by external donors,
and so on. Ceteris paribus, this increased uncertainty would be expressed by giving the intrinsically
weaker bank a lower debt/deposit rating than the intrinsically stronger one.
6 Bear in mind that the concept of “failure” encompasses several scenarios. The closure of a bank may not lead to depositors losing money. Regulators could
take control of a “failed” bank, which could then continue to conduct day-to-day business as before.
As a general principle, we believe that in emerging markets, published figures are more likely to be a
lagging indicator of a bank’s problems rather than a leading one. In emerging markets we cannot rely on
published numbers to signal a developing problem. By the time it is signalled in the figures, the bank may
already be on the point of insolvency.
5.2 The Economy And Environment In Which The Banks Operate Is A Much More Important
Driver Of Financial Strength
This is because the political and economic environment in emerging markets tends to be less stable than
in more developed markets, and because the scale of any change may be far greater. This is true at many
levels. For example:
• A change of government may have a great impact on the structure of the banking system (for example,
if an administration committed to privatisation replaces one which is not) and on the fortunes of indi-
vidual banks (for example, in Turkey the chairmen of state banks are political appointees — a problem
when governments change frequently).
• Banks may be affected by drastic measures taken by the government as part of its wider economic
agenda. For example in April 1998, we noted that in Brazil, a “hike in interest rates to levels of 43%
per annum in October 1997 from an already high 22%, coupled with a fiscal package aiming to save
nearly R$20billion to the Federal Government are causing an economic slowdown and a contraction
in credit demand.” It is unlikely that any developed market bank would have to cope with such huge
changes in the monetary environment.
• Banking systems in transition are by definition more subject to change than those which are mature.
For credit analysts the main implication of this is that the competitive environment may change, exist-
ing banks merge, new banks are created, the role and ownership of banks changed, and non-bank
financial institutions emerge to undermine historic business franchises. Competition will also come
from foreign banks (with more sophisticated systems and far larger resources), depending on the
degree of openness of the market allowed by the government.
We would also point out that in markets where statistics may not be a useful guide to a bank’s financial
strength it is particularly important to understand the general forces which are shaping the banking mar-
ket. Understanding the broader trends helps the analyst to interpret the figures presented by an individual
institution. For example, the huge swings in Turkish banks’ returns on assets are hard to understand
unless one appreciates the country’s hyper-inflationary environment.
5.3 The Strength Of Capital And Provisions Is A More Important Element In The Analysis Of
Emerging Market Banks Than Is The Case With Banks In Developed Markets
In developed markets, a decline in credit quality usually occurs gradually as part of the business cycle giv-
ing banks time to increase provisioning levels over a period of time. In emerging markets credit quality
may deteriorate suddenly.
We believe that a strong earnings base is the best way to safeguard financial strength. Strong earnings
enable a bank to consistently charge off a reasonable quantity of problematic loans without reducing its
equity, or to build capital and reserves against future contingencies. (Banks’ relative strength in this regard
can be compared through their ratios of pre-provision profit to net loans.) In emerging markets there is a
greater possibility that banks’ earnings could be overwhelmed by a dramatic reversal in the economy. In
such circumstances the bank may not be able to spread provisions over time but be forced to cover them
5.4 In Emerging Markets, It Is More Frequently The Case That Bond And Deposit Ratings Are
Either Enhanced By The Likelihood That A Bank Could Be Supported In A Crisis, Or Constrained
By The Limitations Of A Country Ceiling
The possibility that a government or other third party will support a failing bank plays a greater role in
determining debt and deposit ratings in emerging markets. This is partly because bank failure is often a
much more immediate possibility for an emerging market bank than for those in developed markets. But
also, there are a greater number of intrinsically weak banks in emerging markets and some of these oper-
ate in countries where the government has a reasonable ability to ensure that they do not default on their
obligations. For example, Tunisia’s Banque Nationale Agricole is rated E for financial strength, reflecting
our view that the bank is extremely weak, yet it receives a foreign currency deposit rating of Ba1, because
the Tunisian central bank (rated Baa3) would probably be able to prevent it defaulting in a crisis.
On the other hand, because the country ceilings assigned in emerging markets are lower than those in
developing markets, it is more often the case that the ratings of strong banks are constrained. In North
West Europe, all country ceilings are Aa or higher, so few banks are likely to be constrained by a country
ceiling. Emerging markets are rarely rated as high as the A category and usually quite a bit lower. Another
way of conceptualising this is to say that banks face two main risks – bankruptcy and a sovereign-imposed
foreign currency moratorium. In the case of emerging market banks, the latter risk assumes a higher pro-
file, and this translates into lower country ceilings.
The issues which have the potential to affect a bank’s credit quality are the same in every case: they can
be distilled into the seven “pillars” noted above. But in practice, the key issues driving the rating differ
from bank to bank. For one bank, a strong earnings profile may override concerns about forthcoming
deregulation; for another, poor management may lead to a low rating despite strong financial indicators;
and so on. The art of bank analysis lies in identifying the key rating drivers and assessing the extent to
which they will impact the bank’s credit quality over the long term.
Operating conditions are the single most important reason why emerging market banks
as a class receive lower financial strength ratings than those in developed markets.
7.2 Trends In Capital Markets, Disintermediation And Structure Of The Banking System
It is important to understand the banks’ role within the financial system as a whole. We said earlier that
banks tend to dominate the financial system in emerging markets. This dominance gives banks two big
advantages:
• Pricing power – banks are able to determine the “going rate” on deposits and loans, and on fees for
financial services. This power need not be dependent on any cartel arrangements. It may be the outcome
of pricing inertia among the existing players (who have no interest in disturbing pricing structures) and
the absence of new players pursuing an aggressive pricing strategy in order to capture market share.
• Ability to benefit from changes in the public’s asset distribution – for example, the effect of a move out
of bank deposits and into, say, mutual funds, is minimised if banks control the local mutual fund indus-
try. Clearly, issues of funding and liquidity arise, but if banks can recapture in management fees the
margin which they lose from deposit withdrawals, their profitability is protected.
As financial markets develop, new players appear and banks start to lose these two advantages. The
speed at which this takes place depends on several factors, including the attitude of the regulatory authori-
ties to licensing new institutions. Central banks are often very protective of their banking system, and do
not want to see them weakened by new players. The speed of change will also be affected by the potential
for capital market development – a large economy with a diverse corporate landscape and a strong public
sector is more likely to attract the attention of local financial entrepreneurs and foreign institutions seek-
ing a part of the action. A more staid market is likely to be left to the existing players.
The bank analyst therefore needs to consider the franchise which banks have within financial markets,
and the likelihood that this will change. As we indicated earlier, more diverse and mature financial markets
are part of an improved operating environment, so some banks (“winners”) may benefit even if the fran-
chise of banks as a class is weakened. Identifying winners and losers is a central part of this analysis.
Having considered the banks in the context of the financial system as a whole, the next step is to look
at how individual banks will be affected by the changing structure of the banking market. We look to see
whether the regulators are likely to licence new banks to compete with existing players, whether they
encourage or discourage mergers and acquisitions, and whether they will open the market to foreign com-
petitors. In a market where the major players are growing bigger, possibly through mergers or strategic
alliances with foreigners, smaller and weaker banks are likely to be marginalised. Under a non-competitive
and controlled banking system, such small banks may have been able to survive, but as markets are liber-
alised stronger banks are able to pursue aggressive pricing strategies. Economies of scale also come into
play. The most likely trend is for two types of institution to emerge – large banks with a national franchise
and universal operations, and niche or regional banks. Those caught in the middle find it increasingly
hard to survive.
The countries of the Former Soviet Union and Eastern Europe have seen rapid changes in the struc-
ture of their banking systems due to privatisation, the break-up of large banks, and the licensing of new
players, both local and foreign. In that context, a bank which is a leading player today may not be so
tomorrow. And since the regulation of banks is often a highly politicised issue, predicting the structure of
7.5 Transparency
Emerging market banks and banking systems tend to be less transparent than those in developed markets,
and that is an important reason why they tend to be rated lower. Note that such lower ratings are not just
a product of analysts’ conservatism, although that certainly plays a part (when information is incomplete
or unreliable one has to be more cautious). Less transparency in a banking market leads directly to more
banking problems because banks in that market have to make business decisions based on incomplete or
incorrect information and they are therefore more prone to making wrong decisions.
It is also the case that lack of transparency is used to obscure problems – when a financial system or a
bank is sound, regulators tend to advertise the fact. When it is not, they are more inclined to cover it up.
Lack of transparency enables managers to postpone dealing with problems and continue to pretend that
nothing is wrong.
It cannot be stressed too often that an emerging market bank analyst cannot depend
solely on information received directly from banks and regulators.
Most of these warning signs should be evident from the bank’s Annual Report. The value of thorough-
ly reading all the way through a bank’s Annual Report should not be underestimated. In particular, the
initial notes to the accounts covering the basis of presentation should not be overlooked, including, for
example, notes dealing with the basis of consolidation. In addition to answering specific questions the ana-
lyst may have, the Annual Report also gives a good indication of a bank’s general attitude to disclosure.
Quality of disclosure is more important than quantity. The Israeli banking system provides an exam-
ple. Israeli banks’ Annual Reports run to some 200 pages, about 100 which comprise the notes to the
financial statements. Yet, the analyst wanting to know an Israeli bank’s ratio of non-performing loans to
gross loans has a difficult task. The notes to the accounts do not show totalled numbers for non-perform-
ing loans and gross loans. The number can be worked out but errors are easy to make if one is not already
familiar with Israeli banks. The philosophy behind Israeli banks’ disclosure appears to be classification
rather than explanation. Non performing loans are classified into numerous categories – giving a far more
detailed breakdown than one would normally expect. But there is no attempt to consolidate that level of
detail into the type of meaningful ratios which a credit analyst uses. Without considerable additional work
by the credit analyst the numbers do not show whether the bank’s balance sheet is strong or weak. It is a
system designed for the benefit of regulators (whose priority is often classification) rather than for credit
analysts (whose priority is explanation). This is frequently the case in banking systems which used to be
state owned, like Israel’s.
We attach particular importance to the quality of public disclosure, as opposed to information submit-
ted in confidence to rating agencies or other banks. Publicly disclosed information is subject to public
scrutiny and debate and may therefore be more accurate. (For more on the role of transparency see
Moody’s Special Comment Improving Transparency in Asian Banking Systems, November 1998).
7 Privatisation is often advertised well in advance, enabling Moody’s to factor into the ratings the likely loss of state support before it actually occurs.
9. Franchise Value
The value of a bank’s franchise is a key driver of bank financial strength, yet it is a concept which is often
misunderstood in the investor community. Simply put, a bank’s franchise is its ability to generate earnings
over the long term. Many factors feed into this ability – market share, risk profile, strategic choices and
the profitability of the bank’s business lines. But all the factors are ultimately manifest in a very concrete
form – the bank’s income statement. A bank’s franchise can be conceptualised as the present value of all its
future income streams. In crude terms, a strong franchise may be described as the ability to make lots of
money over the long term.
Two types of franchise should be distinguished: system-related and bank-related. A system-related
franchise refers to the profitability of the banking system as a whole, and its ability to maintain that prof-
itability in the face of competition, deregulation or regulatory changes. These issues were considered
above in the analysis of the banks’ operating environment.
A bank’s franchise can be conceptualised as the present value of all its future income
streams. In crude terms, a strong franchise may be described as the ability to make lots
of money over the long term.
9.1 Efficiency
A low cost base enables banks to maintain profitability even if increased competition reduces gross earn-
ings. A bank with a low cost base will be able to ride out a temporary pricing war with other banks, and
will have time to restructure its operations to take account of long term shifts in market pricing. Such effi-
ciency is increasingly driven by technology and product mix – that is, by a bank’s ability to distribute its
products and services effectively and cheaply, and to blend them into powerful marketing combinations.
8 The only qualification we would make to this would be when a specific issue is of sufficient importance that a board member should be designated to watch
over it. Risk management and the Year2000 computer bug would be examples. Even here, the purpose is not to manage that function, but to provide
additional oversight. Another point is that the internal audit committee should report directly to the board.
We look at a variety of ratios in order to get an all round picture of a bank’s profitability. No one ratio
can drive credit quality on its own. In emerging markets, the key indicators of quality earnings include:
Pre-provision return on average assets (sometimes known as “recurring earning power”). This is the
basic measure of a bank’s efficiency – its ability to generate revenues from its balance sheet. We are clearly
focussed on pre-provision return rather than net returns because of the possibility that a bank will be
forced to make sizeable provisions against credit or market losses. We want to assess the bank’s ability to
make such provisions without declaring a net loss. As credit analysts we are more concerned with returns
on assets than return on equity (the latter being of more interest to investment analysts). We recognise the
importance of returns on equity (explained below), but it ranks behind return on assets in importance.
Net interest margin. (NIM — net interest and dividend income divided by average earning assets).
Interest and dividend earnings generate the bulk of a bank’s earnings. The NIM quantifies the efficiency
with which a bank does that. The NIM is a sub-set of pre-provision return on assets, focussing only on the
interest/dividend earning part of the balance sheet. As with all financial ratios, it is important to under-
stand why one bank’s ratio is higher or lower than another’s. For example, a high net interest margin may
be the result of a bank having more of its assets deployed as loans, rather than in government securities or
interbank placements. Such a bank is generating higher returns by accepting greater credit risk and
reduced liquidity.
A bank’s risk profile does not evolve by chance. It is the product of management
strategies…
In emerging markets we are particularly focused on credit risk and operational risk. As in developed
markets, the growth of treasury activity, including the use of derivatives, and recent examples of extreme
market volatility is placing the spotlight on market risk. As emerging financial markets become more com-
plex, banks face a widening array of risks, yet it is credit and operational risk which pose the greatest and
most immediate threats to solvency.
9 In this report, the term NPL is used in its generally accepted sense, meaning a loan which is not being serviced according to the terms under which it was
granted. Typically a loan would be classified as non-performing when interest is more than 90 days past due. In the United States, NPL has a very specific
and, in some respects, different meaning. That is not the sense in which the term is used in this report.
10 This would normally be done on a lagged basis –the increase in NPLs in 1998 might be be compared with the increase in gross loans in 1997.
Emerging market banks’ exposure to market risk is increasing as the banks diversify
their activities away from lending…
Specifically, we would analyse the rationale for a bank’s trading activity (foreign exchange, fixed
income and equities) and the significance which it plays in the bank’s overall earnings profile. We are far
more comfortable with stable and secure trading revenues than those which fluctuate widely from year to
year, even if the latter approach leads to occasional years of spectacular profits. The volume of trading
11 Although the perception that a bank is insolvent often leads to it having liquidity problems.
12 During the civil war in Lebanon, retail depositors kept their money in the local banking system. Withdrawing cash and putting it “under the mattress” would
have been an extremely risky alternative at a time when houses were being commandeered by armed militias, the front line between warring factions was
constantly changing, and personal security on the streets precarious.
There is a common misconception that the more capital a bank has, the stronger the
bank is, and by extension, the higher its rating.
13 In June 1999, proposals to revise the Basle standards were announced. For Moody’s initial reaction to the proposals, see our Special Comment, Implications
for Banks of the Basel Committee’s New Capital Adequacy Proposals, June 1999.
14 “Look Who’s Talking About Capital!”: The Mexican Banking System and Economic Capital.
All too often managers of emerging market banks appear to have little sense of
strategic direction beyond their immediate budget objectives.
When banks find they are running out of opportunities at home, they often try to expand abroad. We
are sceptical of the value of such overseas initiatives unless there is a tie-in to the domestic market (eg,
trade and investment flows), or unless the bank is large enough to be a reasonably significant player in
whatever overseas markets it enters. Lending money as junior members of loan syndicates, in countries far
from the bank’s home base, to clients with whom it has no chance of winning related business (such as
L/C confirmations) is frequently a recipe for losses, however attractive the loan spreads may appear when
the money is offered. Many of the larger emerging market banks strain at the limitations of their domestic
economies. Cautious expansion into neighbouring countries where risks are well understood is one solu-
tion, but beyond that we think that the bigger emerging market banks would often be better off accepting
their fate as large banks in small markets, rather than embarking on over-ambitious strategies to become
medium sized players on the international stage.
15 Mutual status can be a constraint in this respect, since a mutual bank would normally have to incorporate as a Public Limited Company (PLC) before being
able to buy or merge with another PLC. However, the experience of European mutuals is solutions to this problem are often available.
To order reprints of this report (100 copies minimum), please call 800.811.6980 toll free in the USA.
Outside the US, please call 1.212.553.1658.
Report Number: 46631