How CRISIL factors government support into bank ratings
Likelihood of government support is important, not decisive
N.Muthuraman Director - Criteria and Product Development Tel: 91 (22) 6691 3118 Email: [email protected]
This opinion piece clarifies CRISIL’s approach to factoring the possibility of government support into ratings of financial sector entities. The question assumes importance in the context of heightened investor interest and debate on this issue in recent months in global financial markets.
Governments have often infused funds into banks and financial institutions (FIs) in distress, to allow them to service debt obligations on time; such support, however, is rarely absolute or automatic. CRISIL believes – based on evidence from India and the rest of the world – that the likelihood of government support is best viewed as a continuum: a small number of entities are certain to receive support in case of distress, a few others in the sector are highly unlikely to get it, and the vast majority fall somewhere in between on the scale.
Government-owned banks in India: a history of selective support
Government-owned banks and FIs in India are near the high end of the scale in terms of the likelihood of support, but CRISIL does not believe that such support will be automatic.
There are four reasons for this. Firstly, the government has not at any point stated its intention to support these banks’ obligations, especially their non-deposit ones. Secondly, with the gradual reduction of government shareholding in banks and FIs, there has been a corresponding increase in their functional autonomy, reducing the degree of operational linkage to government. Thirdly, the fiscal situation of the government may be under pressure if a number of government-owned banks and FIs seek support simultaneously in a systemic crisis. And, finally, there is the question of moral hazard: the knowledge that rescue will be automatic can lead to risky operations – particularly lending – which the government would want to discourage.
In practice, government or public sector ownership has, by itself, not guaranteed support. IFCI Limited, a large public sector- owned financial institution with significant public debt, went into default a few years ago;
the government did not provide timely support to prevent the default. On the other hand, Indian Bank Limited, a large government- owned bank, received re-capitalisation assistance, and was thereby rescued in time by the government.
CRISIL believes that with such historical divergence in government behaviour, it is not possible to rigorously quantify or model the likelihood that the government will ensure timely servicing of a troubled government- owned bank’s or FI’s debt obligations. Even more difficult to quantify is the possibility of support when obligations consist of subordinated debt and other hybrid instruments. Therefore, it is – in CRISIL’s view – analytically incorrect to assume blanket support for all banks and FIs at all points of time, and assign government-like ratings to all such entities.
Instead, CRISIL answers the question by applying a sophisticated set of criteria that calibrate the incentives for the government to support a government-owned entity. The key factors that CRISIL assesses are:
o The strategic importance of the entity to the government and its public policy role
o The criticality of the sector to the economy
o The political implications of default o The economic costs of default to the
government, and impact of default on the financial system’s stability
o A public perception of sovereign backing for the entity
April 2007
o The publicly stated posture of the government
Based on this assessment, CRISIL classifies government owned entities into one of four categories: equated ratings, high likelihood of support, minimal likelihood of support, and no support. In CRISIL’s opinion, government- owned banks and FIs fall in the second category, with a high likelihood of support:
they clearly score well on several of the above parameters, but not enough for their credit to be equated to the government’s, for the four reasons that were articulated at the start of this section. This provides for a notch-up from their standalone ratings, but does not automatically translate into ‘AAA’ ratings for all of them. Thus, though government support is an important factor in CRISIL’s rating methodology, the bank’s or FI’s own financial and business risk profile plays a far more significant role in arriving at the final rating.
Private banks are less likely to receive support than government-owned ones
Although the government does not own private banks, it could still step in to prevent them from defaulting, to ensure the stability of the financial system. On occasions when such banks were close to failure, the Reserve Bank of India (RBI) often acted in a timely manner to safeguard the financial system’s stability; as a
result, only equity investors faced significant erosion in value (at times even a complete write-down of equity, as was the case in Global Trust Bank Limited). In future, however, such action may not necessarily ensure full and timely repayment to all subordinated debt holders and to investors in hybrid debt. CRISIL therefore does not normally factor in any explicit government support for private sector banks. However, the systemic importance of these banks, and the liquidity they can draw upon (such as the call money markets and repo facilities with RBI), are factored into their ratings.
Beyond quantitative models
CRISIL believes that the likelihood of government providing distress support to banks and FIs is not absolute; any attempt to model it quantitatively leads, in CRISIL’s opinion, to misleadingly precise conclusions.
While rating government-owned banks and FIs, CRISIL treats the possibility of government support as an overlay, but the ratings are primarily driven by the stand-alone credit strengths of these entities. CRISIL believes that these ratings reflect an accurate assessment of the credit quality of rated instruments issued by such entities, meeting the highest standards of analytical rigour that CRISIL adopts in all its ratings.
India’s leading Ratings, Research, Risk and Policy Advisory company
DISCLAIMER
CRISIL has taken due care and caution in preparing this report. Information has been obtained by CRISIL from sources which it considers reliable. However, CRISIL does not guarantee the accuracy, adequacy or completeness of any information and is not responsible for any errors in transmission and especially states that it has no financial liability whatsoever to the subscribers/ users/ transmitters/ distributors of this report. No part of this report may be reproduced in any form or any means without permission of the publisher. Contents may be used by news media with due credit to CRISIL.
©
CRISIL. All Rights ReservedHead Office:
CRISIL House, 121-122, Andheri-Kurla Road, Andheri East, Mumbai - 400 093 Tel: +91-22- 66913001-9 Fax: +91-22- 66913000
www.crisil.com