Regulatory Framework and Role of Domestic Credit Rating Agencies in Bangladesh Recently, the rating assessment by Domestic Credit Agencies (DCRAs) in Bangladesh has become crucial in calculating the capital adequacy for commercial banks. The use of credit rating is to lead to establishing acceptable measures of credit risk evaluation for commercial banks to meet Basel II regulatory prescriptions. Furthermore, Bangladesh Bank plans to introduce ratings for small and medium-sized enterprises (SMEs) and a customized credit assessment framework for SMEs apart from the usual bank loan ratings. Credit ratings could fill a critical gap in the credit information continuum, moving away from collateral-based lending to risk-based lending for SMEs. South Asia Working Paper Series About the Asian Development Bank ADB’s vision is an Asia and Pacific region free of poverty. Its mission is to help its developing member countries reduce poverty and improve the quality of life of their people. Despite the region’s many successes, it remains home to two-thirds of the world’s poor: 1.7 billion people who live on less than $2 a day, with 828 million struggling on less than $1.25 a day. ADB is committed to reducing poverty through inclusive economic growth, environmentally sustainable growth, and regional integration. Based in Manila, ADB is owned by 67 members, including 48 from the region. Its main instruments for helping its developing member countries are policy dialogue, loans, equity investments, guarantees, grants, and technical assistance. Regulatory Framework and Role of Domestic Credit Rating Agencies in Bangladesh Jiro Tsunoda, Muzaffar Ahmed, and Mohammed Tajul Islam No. 21 | November 2013 Asian Development Bank 6 ADB Avenue, Mandaluyong City 1550 Metro Manila, Philippines www.adb.org/poverty Publication Stock No. WPS?????? Printed on recycled paper Printed in the Philippines ADB South Asia Working Paper Series Regulatory Framework and Role of Domestic Credit Rating Agencies in Bangladesh Jiro Tsunoda, Muzaffar Ahmed, and Jiro Tsunoda is principal portfolio management specialist, Mohammed Tajul Islam Asian Development Bank. Muzaffar Ahmed is president and CEO, Credit Rating Information and Services, No. 21 November 2013 Bangladesh. Mohammed Tajul Islam is vice president and head of ratings, Credit Rating Agency of Bangladesh. Asian Development Bank 6 ADB Avenue, Mandaluyong City 1550 Metro Manila, Philippines www.adb.org © 2013 by Asian Development Bank November 2013 Publication Stock No. WPS146204 The views expressed in this paper are those of the author and do not necessarily reflect the views and policies of the Asian Development Bank (ADB) or its Board of Governors or the governments they represent. ADB does not guarantee the accuracy of the data included in this publication and accepts no responsibility for any consequence of their use. By making any designation of or reference to a particular territory or geographic area, or by using the term “country” in this document, ADB does not intend to make any judgments as to the legal or other status of any territory or area. Note: In this publication, “$” refers to US dollars. The ADB South Asia Working Paper Series is a forum for ongoing and recently completed research and policy studies undertaken in ADB or on its behalf. The series is a new knowledge product and replaces the South Asia Economic Report and South Asia Occasional Paper Series. It is meant to enhance greater understanding of current important economic and development issues in South Asia, promote policy dialogue among stakeholders, and facilitate reforms and development management. The ADB South Asia Working Paper Series is a quick-disseminating, informal publication whose titles could subsequently be revised for publication as articles in professional journals or chapters in books. The series is maintained by the South Asia Department. The series will be made available on the ADB website and in hard copy. Printed on recycled paper CONTENTS I. THE GENESIS OF DOMESTIC CREDIT RATING AGENCIES IN BANGLADESH 1 II. CREDIT RATING AGENCIES IN BANGLADESH THAT ARE RECOGNIZED AS 2 EXTERNAL CREDIT ASSESSMENT INSTITUTIONS BY BANGLADESH BANK III. HOW RATING AGENCIES ARE GOVERNED GLOBALLY 3 IV. REGULATORY FRAMEWORK FOR DOMESTIC CREDIT RATING AGENCIES 3 IN BANGLADESH A. Credit Rating Companies Rules 1996 3 B. Dhaka Stock Exchange Direct Listing Rules 4 C. Banking Regulation and Policy Department, Bangladesh Bank, 4 Circular Number 05 Dated 29 May 2004 and Circular Number 06 Dated 13 March 2011 D. Guidelines of Bangladesh Bank for Capital Adequacy Framework 5 and Accreditation of External Credit Assessment Institutions E. Circular of the Chief Controller of Insurance 5 V. PERFORMANCE OF DOMESTIC CREDIT RATING AGENCIES IN 6 BANGLADESH WITH REFERENCE TO THE ADB HANDBOOK ON BEST PRACTICE COMPLIANCE VI. CREDIT INFORMATION BUREAU VERSUS CREDIT RATING AGENCY 7 A. What Is a Credit Information Bureau? 7 B. Credit Information Bureau in Bangladesh 7 C. Regulatory Framework for the Credit Information Bureau in Bangladesh 8 D. Credit Information Bureau versus Credit Rating Agencies 9 VII. IMPLEMENTING THE BASEL II GUIDELINES OF CAPITAL ADEQUACY 9 FRAMEWORK FOR COMMERCIAL BANKS AND THE ROLE OF DOMESTIC CREDIT RATING AGENCIES A. Status of External Credit Assessment Institutions 11 B. Monitoring and Mapping the Rating Quality of External Credit 12 Assessment Institutions C. Risk Weight Assignment under Basel II and Prospects of External 15 Credit Assessment Institutions D. Basel II Implementation: Bankers’ Challenges in Credit Risk Rating 16 VIII. INTERNAL CREDIT RATINGS BY COMMERCIAL BANKS IN BANGLADESH 21 IX. PROSPECTS FOR CREDIT RATING IN BANGLADESH WITHIN A 22 BASEL II REGIME X. BANGLADESH BANK’S MOVE TOWARD RATING SMALL AND 23 MEDIUM-SIZED ENTERPRISES XI. CONCLUSIONS 24 APPENDIXES 1. ADB Best Practice Handbook 25 2. Credit Rating System Development for Small and 27 Medium-sized Enterprises A. Background 27 B. Inadequate Funding—A Key Constraint to Growth of Small and 27 Medium-sized Enterprises C. How Recognized Domestic Credit Rating Agencies Can 29 Contribute to Credit Rating and Development of Small and Medium-sized Enterprises D. Mapping Rating Factors to Rating Categories 30 E. Deriving Ratings through the Scorecard 32 F. Proposal for a Rating Fund for Small and Medium-sized 34 Enterprises G. How Would the Rating Fund for Small and Medium-sized 35 Enterprises Bring Benefits for the Segment? TABLES AND FIGURE Tables 1 Road Map for Implementing the BASEL II Capital Adequacy Framework in 10 Commercial Banks 2 Mapping of Bangladesh Bank’s Rating Grade with Rating Scales 13 3 Long-Run “Reference” 3-Year Cumulative Default Rate 13 4 Three-Year Cumulative Default Rate Benchmark 14 5 Risk Weights by Claim Type 15 6 Mapping the Ratings of Credit Rating Information and Services and Credit 17 Rating Agency of Bangladesh on the Bangladesh Bank Rating Grade 7 Revised Mapping of Bangladesh Bank’s Rating Grade with Rating Scales 18 8 Number of Ratings by Rating Agency 19 9 Distribution of Ratings in 2012 by Long-Term Rating Notch 20 10 Distribution of Ratings in 2012 in Percentages 20 11 Distribution of Ratings in 2012 by Investment Grade Category 20 12 Banking Sector in Bangladesh 21 13 Categorization of Small and Medium-sized Enterprises in Bangladesh 23 Appendix Tables A2.1 Proposed Rating Scale for Assessing Credit-Quality Ratings Assigned by a 30 Domestic Credit Rating Agency to a Small or Medium-sized Enterprise A2.2 Rating Factors and Sub-Factors and Their Weights 31 A2.3 Conversion of Factor Ratings into Numeric Values 31 A2.4 Rating Scorecard for a Small or Medium-sized Enterprise 32 A2.5 Factor Numeric Table of Small and Medium-sized Enterprises; 8-Notch 33 Rating Scale Appendix Figure A2 Credit Rating Scheme in Bangladesh for Small and Medium-sized Enterprises 35 ABSTRACT The Securities and Exchange Commission Bangladesh (SECB) promulgated the Credit Rating Companies Rules, 1996 for investor protection in issuing debt securities and public issue of shares. Two domestic credit rating agencies (DCRAs) were licensed by SECB after 2002, which were later accorded status of external credit assessment institutions (ECAIs) by Bangladesh Bank. Thereafter, SECB and Bangladesh Bank issued rules and regulations towards mandatory ratings which led to the building of information frameworks critical to the efficiency of financial markets. Investors could now optimize their risk–return profiles, monitor their portfolios through regular surveillance and credit rating adjustments, and have timely information for trading and risk management. Recently, DCRAs have come to play a more crucial role since the capital adequacy of commercial banks has been tied to rating assessment of bank investments. The use of credit rating is expected to lead to the establishment of acceptable measures of credit risk evaluation so that commercial banks can meet Basel II regulatory prescriptions. As Bangladesh Bank accords ECAI status to more DCRAs, banking sector financing to corporate borrowers is receiving a boost. The number of DCRAs operational in Bangladesh has risen from two to seven between 2010 and 2013. Furthermore, Bangladesh Bank plans to introduce ratings for small and medium-sized enterprises (SMEs) and a customized credit assessment framework for SMEs including a separate rating scale and notation that sets SME ratings apart from the usual bank loan ratings. Access to adequate financing is still a chronic problem for SMEs in the Asian region and here, credit ratings