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Bank Credit Risk Methodology

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By Whitehall Capital Partners


The purpose of this document is to outline our approach and elaborate on the methodology chosen to rate Banks Banks require strong business franchises in order to generate profits over the long term. They need competent management teams in order to do this. In both cases, our analysis will assess the banks’ vulnerability to deterioration in economic conditions and the effects of changes in the regulatory environment. And in both cases, we will consider a bank’s financial condition, both in absolute terms and in relation to their peer groups. Incorporating both quantitative and qualitative factors, our ratings reflect an evaluation of the organization’s current financial position, as well as how the financial position may change in the future. In its quantitative analysis, it focuses on fundamentals, analyzing an institution’s historical and current financial performance and using this as a foundation for developing expectations regarding its future financial performance and risk profile, under both normal and stressful operating scenarios. In establishing other strengths and weaknesses that could potentially influence an institution’s future financial performance, emphasis is also placed on assessing the operating environment (including both economic and industry risk), strategy, market position, diversification, depth of management, as well as risk management policies and procedures.


The Below Is Used To Assess The Credit Rating Of Banking Institutions. If Your Institution Lends Money Out, Trades/Invests In Any Of The Following It Is Taking On Credit Exposure:

  •  Bonds;
  • Commercial Paper – An unsecured obligation issued by a corporation or bank to finance its short-term credit needs, such as accounts receivable and inventory. Maturities typically range from 2 to 270 days. Commercial paper is available in a wide range of denominations, can be either discounted or interest-bearing. Commercial paper is usually issued by companies with high credit ratings, meaning that the investment is almost always relatively low risk

  • Notes, Bankers acceptances
  • Bank deposits
  • Total Return Swaps and other derivative products
  • Repos
  • Securities/cash trading (settlement and pre-settlement risks)
  • Currency trading
  • Stock Borrowing
  • Short Selling
  • Loans


  • The vital role banks play in the country’s macroeconomic and monetary policies.
  • The regulatory supports and regulatory mandates affecting bank’s operations and activities.
  •  The highly leveraged nature of a bank’s operation – relying on earnings derived from leveraging of capital within the regulators guidelines
  •  The need for banks to adroitly manage and control risks – market, credit, liquidity and operational risks.
  •  The cyclical nature of the industry. Banking operations are subject to credit business cycles of industries and to consumer credit trends, in addition to economic factors.

Key individual bank-specific issues taken into consideration when assigning ratings include:

  • The competitive and regulatory environment
  • Management and strategy; including staff productivity
  • Funding and liquidity
  • Financial leverage
  • Capital adequacy
  • Earning sources and sustainability
  •  Risk management

When conducting a rating it is necessary to assess the bank both qualitatively and quantitatively. Each of the elements will be presented within the more general categories of balance sheet strength, operating performance and business profile below.


The rating tools aim to assess each institution no matter the jurisdiction with a common accounting standard. In this way we can ensure that the ratings are consistent. In this way IAS has been selected. Preparing accounts to IAS standards requires a greater degree of discretion and analysis of a bank’s economic activity.

Balance sheets are structured differently in different regions, it is therefore essential for the analyst to identify the differences between local accounting standards and the IAS.


The quantitative section uses various financial ratios to determine the financial strength and credit worthiness of the financial institution. The model is best suited to pure commercial or universal banks and should not be used for pure investment banks.

Each of the sections has warning signals which the analyst is expected to take into account when rating the institution. The final rating of the institution shall be based on the analyst’s judgment. The model serves as a guide to assist the analyst in reviewing and rating the Bank.



Balance sheet strength indicates four elements managed by the Bank with respect to its operating and financing needs, both on a current basis and under stressed conditions.

These are:

  • Capital adequacy – reveals whether

   a bank has enough equity to support the risk on its balance sheet

   asset growth can be supported by proportionate equity growth

   a bank has capacity to market long term debt

   Capital is being eroded by excessive dividends.

  • Total assets – The total assets of banks are an aggregate of the asset and liability items in the balance sheet. Assets are bought to increase the value of a firm or benefit the firm’s operations. An asset can be thought of as something that can generate cash flow.
  • Capital to Asset Ratio (Total Capital/Total Assets)- This can help to determine the solvency of the bank. It expresses the proportion of total assets financed by the firm’s total capital. Total capital is measured as follows: Tier 1 equity capital (common stock and qualifying preferred stock), plus Tier 2 capital (reserves for loan losses, subordinated debt, and preferred stock not counted as Tier 1 capital).


  • Credit risk (asset quality) – a significant component of a bank’s risk lies in the quality of its assets and in particular its loan assets. A review of the bank’s credit risk examines the composition, diversity and quality of both its on and off-balance sheet assets in terms of repayment versus loss potential. Primary asset quality ratios which will be used are as follows:
  • Nonperforming loans to total loans – provides historical indication of a bank’s credit portfolio, resulting from its credit underwriting criteria and market strategy. The level of the ratio should be viewed in the context of its market base and peer group, as non-performing loans are an inevitable cost of doing business, however an important indicator of the bank’s ability to vet its borrowers.
  • Provision for loan losses to non-performing loans – measures the set-aside of capital by management for actual charge-offs of loans. Core earnings consist of pre-provision income and are first line of protection for banks against loan losses before capital is affected.
  • Loan loss reserve to total loans – because some proportions of non-performing loans eventually become actual charge-offs; this ratio can be a good indicator in trends of credit quality of a bank as it measures the degree to which a bank has reserved for potential loss in relation to its total outstanding loan portfolio.
  • Loans to Total assets – measures the total loans outstanding as a percentage of total assets. The higher this ratio indicates a bank is loaned up and its liquidity is low. The higher the ratio, the more risky a bank may be to higher defaults.

WARNING SIGNS (size and capital and asset quality)

  • Rapid growth in assets – picking assets others do not want
  • Risk Asset concentrations – geographic/industry
  • Over-expansion/Overtrading/Foreign Exchange speculation
  • Intra-group lending
  • Lack of Credit Control
  • Over exposure to highly volatile investments including stocks


To secure the liquidity required by their activities, banks rely on external funding, deposits, bonds or other banks’ loans. The funds will only be available if the providers of funds are convinced that they will get their money back. This requires the bank to maintain adequate capital to absorb unforeseen losses. The larger the capital, and thus the leverage, the safer the bank is and appears to be. For this same reason a bank must remain liquid, to be able to meet cash demands.

Funding liquidity – a bank’s liquidity demonstrates the banks’ ability to accommodate decreases in deposits and other liabilities efficiently and economically, as well as to fund increases in assets. Liquidity can be thought of as a defense mechanism that protects capital form losses on unscheduled asset sales. Ratios considered are as follows:

  • Gross loans to total customer deposits – This ratio indicate the extent to which the bank funds its loans with customer deposits (low cost deposits). Loan assets are the core asset of a bank and are also generally the most illiquid asset class of a bank. Accordingly they require a stable source of funding. Growth rate of loans should be proportional to growth rate of deposits.
  • Liquid assets to total deposits – measures the proportion of total assets readily convertible into cash that a bank must maintain in order to repay deposits on demand. Maintaining liquid assets on the balance sheet is a cost to banks, as the return on those assets is lower than the return on risk assets. An efficient bank must therefore finely balance this, while maintaining the highest possible standards of creditworthiness.
  • Customer deposits to Total deposits – to determine the proportion of customer deposits which is a cheaper form of funding the book and also more reliable as it’s widely spread mitigating against concentration risk. At least about 70-80 percent of deposits should be from customers as opposed to interbank.


  • Over-dependence on interbank market for funding
  • In-house bank
  • Liability mismanagement


  • Earnings Generation (Operating efficiency) – a company’s capital base can be eroded if a company lacks strong operating performance. Operating performance is assessed with an emphasis on franchise strength, profitability of operations, structure and composition of revenues and expenses. Long term viability of a commercial bank is determined by its profitability. Healthy commercial banks usually have solid, sustainable earnings generated from normal banking activities, or core earnings (interest income, fee income, operating income. Non-core income consists of trading income, investment income and non-recurrent income. Sustainable earnings are a source of capital to fund growth, to help maintain an adequate source of liquidity and to protect against a reasonable level of asset losses.
  • Net interest income to average earning assets – net interest margin measures the difference between what we pay for deposits and borrowings and what we earn on loans and investments. It is sometimes referred to as the profit margin on money. Since net interest income is a component of the efficiency ratio, improving the margin will improve the efficiency ratio
  • Fees and commissions to average earning assets – to measure how much of the banks income is due to noninterest revenue. The larger this % the less reliant the bank is on revenue from loans and trading securities such as CPs, bonds etc.
  • Cost to income ratio – It is useful to measure how costs are changing compared to income – for example, if a bank’s interest income is rising but costs are rising at a higher rate looking at changes in this ratio will highlight the fact. The cost/income ratio reflects changes in the cost/assets ratio and in interest margin
  • Return on average equity – pre-provisional income (PPI) to average shareholders’ equity indicates the earning performance of a bank from the perspective of shareholders and the equity market. PPI has been used instead of Net income to reduce influence of tax planning and permanent changes in provisions requirements.
  • Return on average assets – PPI to average assets reflects earning performance of a bank on its assets relative to its peers.
  • Return on Earning Assets – It measures the results of operations prior to funding costs and as if the operations were totally funded by equity. It includes Revenue from loans, securities, cash equivalents and earning assets (including non-interest) before interest expense / Earning Assets
  • Operating Profit Margin – It measures the percent of net operating revenues consumed by operating expenses, providing the remaining operating profit (the higher the margin the more efficient the bank).
  • Average Collection of Interest (Days) – It is the measurement of the number of days interest on earnings assets remains uncollected and indicates that volume of overdue loans is increasing or repayment terms are being extended to accommodate a borrower’s inability to properly service debt.
  • Overhead Ratio – It is the ratio of Total Non-Interest Expenses (annualized) / Total Average Assets. Non-interest expenses (annualized) are the normal operating expense associated with the daily operation of a bank such as salaries and employee benefits plus occupancy / fixed asset costs plus depreciation and amortization. These costs tend to rise faster than income in a time of inflation or if the institution is expanding by the purchase or construction of a new branches. Provisions for loan and lease losses, realized losses on securities and income taxes should not be included in non-interest expense.
  • Efficiency Ratio – It is a measure of productivity of the bank, and is targeted at the middle to low 50% range. This may seem like break-even but it is not; what this is saying is that for every dollar the bank is earning it gets to keep 50 cents and it has to spend 50 cents to earn that dollar. The ratio can be as low as the mid to low 40% range, which means that for every dollar the bank earns it gets to keep 60 cents and spends 40 cents, a very efficient bank. Ratios in excess of 75% mean the bank is very expensive to operate


  • Paying more than market rates
  • Poor performance/deteriorating ratios
  • Accepting high risk/return business


The qualitative rating aims to look beyond the financial well-being of the bank. The qualitative rating aim to look beyond the financial statements and incorporate information on the Bank’s competitive and regulatory environment, Management and strategy, Business development and risk management capabilities.


This section of the rating allows us to differentiate between the various banks where similarities exist. Whilst this section does not explicitly analyze any sector-specific characteristics/issues, such as already existing rating systems do, for instance, this section nevertheless considers both the company risk and the banking risk together in order to come to a balanced assessment of credit quality. We take into account the Institutions ability to raise funds from the capital markets; this essentially allows the analyst to make a judgment on the market perception of the bank.

Banks who have major exposures concentrated in a single sector or name are viewed as more risky that those who have adequately diversified their investment/banking activities. Whilst the great majority of related-party transactions are perfectly normal, the special relationship inherent between the involved parties creates potential conflicts of interest which can result in actions which benefit the people involved as opposed to the shareholders. For example, in the infamous Enron scandal, related-party transactions with “special-purpose entities” were used to help the company misreport their accounting numbers. In this way the analyst has to analyze the annual report and take a view on the type of related party transactions that exist.

Risk management Capability – the analyst has to take a view as to whether the Bank has sufficient risk management structure in place and the extent it believes the banks activities are risky. Questions that should be asked when making this assessment are as follows:

  • What % of assets is due to volatile (risky) investments?
  • Does the Bank have a risky lending policy?
  • Assessment on adequacy of various committees (ALM, Credit, Operational etc.).
  • Terms balance estimation – to what extent are assets and liabilities matched in terms of maturity?


This section aims to rate the institution in terms of its geographical coverage, business diversity and market share. The more diverse the company, the more vulnerable the Financial institution.


The analyst is expected to make a judgment on the timelines of the institutions Financial Reporting, the quality of the auditors and the extent to which the institution has adhered to accounting standards.


In this section the analyst makes an assessment of the reputation of the owners and the extent to which the ownership structure is transparent. An assessment of the management quality and strategic focus is also necessary. Lastly a score is given based on the age of the institution.


In this section we examine the support structure of the institution. The highest level of support is governmental support in times of crisis. Whilst most banks do not have credit agreements or guarantees from banks in terms of explicit support from the government the analyst will make a judgment of the effect bankruptcy of such institution would have on the economy and therefore decide on what level of support the government would provide. However in many countries banks are still owned/part owned by government in this way we feel that government support is explicit. The same can be said for parental support although we feel this does not carry the same weight as governmental support.


  • Share price volatility; this must however be reviewed in line with capital market volatility.
  • Changes in management
  • Complex/fragmented ownership
  • Inconsistent or opaque accounting
  • Fragmented supervision
  • Rumours on money markets – treasury
  • Delayed financials
  • No apparent lender of last resort
  • Litigation
  • Non-core business
  • Problems with Central Bank
  • Lavish outgoings
  • Autocratic management
  • Fraud


The rating template is one of the tools to be used in assessing the credit worthiness of a company. The final assessment relies on the expert opinion of its credit analysts in coming up with a final review and rating.

The analyst will have information regarding the institution which would not come to light if we simply used the rating tool to assess credit worthiness; therefore we rely on the expert opinion of the analyst to defend the rating.

The qualitative and quantitative sections both carry the same weight. It is possible for an analyst to either upgrade or downgrade a rating based on information he has gathered from the market, more recent interim results etc. the final rating will be based on the score provided from this tool and the analyst review, which he/she will need to present to the credit committee whilst requesting limits.

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