Corporate Governance of Banks:

A Credit Rating Agency’s Approach

presented by Janet Holmes

Overview

„ Introduction

„ Meaning of credit ratings

„ Moody’s general approach to corporate governance

analysis

„ Moody’s Bank Financial Strength Ratings: Global

Methodology

„ Moody’s corporate governance analysis of banks

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Meaning of credit
ratings

3
 What a Credit Rating Is

„ An opinion about the relative future credit risk of an

instrument or entity
– Credit risk is the risk that an entity might not meet its contractual,
financial obligations as they come due
„ Moody’s credit ratings are opinions about expected loss
– Expected loss = (probability of default) x (severity of default)

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 ... and What It Is Not

„ Credit ratings do not address any other risk, including

(but not limited to) the instrument’s:
– Liquidity risk
– Market value risk
– Price volatility
„ Credit ratings are not statements of current or
historical fact
„ Credit ratings are not recommendations to buy, sell or
hold any securities
„ Credit rating agencies are not gatekeepers

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Moody’s Credit Rating scale
Long-Term
Rating
Aaa Minimal credit risk
Investment Grade

Aa1
Aa2
Aa3
A1
A2 Watch list =
A3 under review
Baa1
Baa2
Baa3
Ba1
Ba2
Non-Investment

Ba3
B1 Outlook =
B2 likely direction
Grade

B3
Caa1
Caa2
Caa3
Ca
In default,
C little prospect of recovery 6
Moody’s General
Approach to
Corporate
Governance
Analysis

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Moody’s Corporate Governance Specialists

„ Subset of a larger group of specialists, who work side-

by-side with credit analysts
– Accounting specialists
– Risk management specialists
– Complex financial instruments specialists
¾ Corporate governance specialists
„ Expertise leveraged through training for Moody’s credit
analysts
– Enhances the ability of credit analysts to identify, analyze & incorporate
governance analysis into their credit analysis

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Moody’s Approach to Corporate Governance Analysis

„ Integrate governance analysis into overall credit rating

– How does a firm’s governance affect its ability & willingness to honor its
obligations?
– Is governance a ratings driver?
„ Increase transparency of governance analysis
– Incorporate analysis into Credit Opinions and Credit Analyses
– Publish Issuer Comments if appropriate
– Publish Special Comments to help investors identify and analyze credit-
relevant corporate governance issues and trends
• Sector comments (e.g. governance trends in banking industry)
• Thematic comments (e.g. executive pay)
„ Geographic scope
– To date, principal focus has been North American companies
– Global banking methodology incorporates governance analysis

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Moody’s Approach to Corporate Governance Analysis

„ Qualitative emphasis
– Not a “check-the-box” approach
„ Bondholder perspective
– Like shareholders, concerned about agency issues & adequacy of controls
– But risk appetites differ between bondholders & shareholders
„ We evaluate governance in terms of:
– Quality of governance practices
– Degree to which the board & management have shown that they
effectively balance shareholder and bondholder interests
„ Context-specific assessments
– Linked to broader view of creditworthiness
– Take into account ownership structure, market discipline & regulatory
environment

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Integrating governance into ratings analysis

„ Governance can be an important ratings factor

„ Even in large issuers, governance has been a material
rating factor about 20% of the time (10% positive, 10%
negative)
„ For lower-rated, smaller issuers, governance can be a
more important factor in ratings
„ Can provide additional insight into management quality,
event risk & strategy

Governance
Governanceis israrely
rarelyaacentral
centralratings
ratingsissue;
issue;
but
butoften
oftenserves
servesasasaa“tipping
“tippingpoint”
point”factor
factor

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 We Characterize Governance in Five Categories

Impact on
Ratings

Very Good
Governance is a credit strength +

Governance strengths outweigh some

Neutral
weaknesses
Corporate governance is neither a positive
Neutral
nor negative rating factor
Governance weaknesses outweigh
strengths
−

−
Governance is a credit challenge that could
Very Weak constrain future ratings improvements

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Moody’s Supports Good Governance Principles

„ Appoint independent, effective directors

„ Establish independent, technical committees
„ Set strong values
„ Adopt clear lines of accountability
„ Maintain strong, independent control functions
„ Ensure oversight of complex organizations, financial
instruments
„ Ensure high quality governance transparency
„ Adopt long-term compensation structures

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 Disclosure about Governance
„ Board structure (e.g. bylaws, size, membership, selection process,
qualifications, other directorships, criteria for independence,
committee membership, charters and responsibilities) and senior
management structure (e.g. responsibilities, reporting lines,
qualifications and experience)
„ Basic ownership structure (e.g. major share ownership and voting
rights, beneficial owners, major shareholder participation on the board
or in senior management positions, shareholder meetings)
„ Organizational structure (e.g. general organizational chart, business
lines, subsidiaries and affiliates, management committees)
„ Incentive structure of the firm (e.g. short and long term
compensation policies, director and executive compensation, bonuses,
stock options, key metrics considered in deciding compensation)
„ Firm’s code or policy of business conduct and/or ethics
(including any waivers, if applicable), as well as any applicable
governance structures and policies

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Moody’s Approach
to Analyzing
Corporate
Governance of
Banks

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Moody’s Bank Financial Strength Ratings (BFSRs)

„ A BFSR reflects Moody’s opinion of a bank’s

intrinsic, or stand-alone, financial strength
– Relative to all other rated banks globally
– The first step in Moody’s credit rating process
– But BFSRs are not credit ratings – do not address default risk or
severity of loss
– BFSRs address likelihood that a bank would need assistance to
avoid a default
„ Moody’s other ratings for banks determined by
considering its BFSR plus:
– Likelihood that bank will receive external support
– External risk that sovereign actions could interfere with the bank’s
ability to honor domestic or foreign currency obligations

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 Bank Ratings

Local Currency Foreign Currency

Franchise Value
Deposit Ceiling Deposit Ceiling

Risk Positioning

Bank Local Foreign

Financial Currency Currency
Operating Deposit Deposit /
Environment Strength
/Debt Debt
Rating Rating Rating
(A – E) (Aaa - C) (Aaa – C)

Financial
Fundamentals

Regulatory Probability of
External
Avoiding FC
Environment Support Factors Moratorium
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INTRINSIC FACTORS EXTERNAL FACTORS
BFSR Rating Definitions
„ A: Superior intrinsic financial strength
„ B: Strong intrinsic financial strength
„ C: Adequate intrinsic financial strength
„ D: Modest intrinsic financial strength
„ E: Very modest intrinsic financial strength

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BFSRs – Key Analytical Factors

„ Franchise value
„ Risk positioning
¾ Where corporate governance is considered

„ Regulatory environment
„ Operating environment
„ Financial fundamentals

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Sound Controls Support Strong Credits
„ Strong franchise and financial fundamentals, plus
„ Sound regulatory environment
„ Strong risk management
„ Robust corporate governance

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Moody’s Has Stepped up Its Analysis of Controls

„ Longstanding focus (before 2003)

– Regulatory environment
– Credit/market risk controls
„ Added specialist team support (2003-2007)
– Specialist teams led to more systematic analysis of:
• Governance
• Risk management
• Control failures
„ Incorporation into revised BFSR Methodology (2007+)
– Dynamic assessment of governance & risk management
embedded in analysis
– Controls history also considered

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Factor 2: Risk Positioning

„ Why it matters
– Majority of revenue for most banks is compensation for
taking calculated risks
– Management’s approach to managing risks underpins its
strategic decisions & the probability of those decisions
succeeding
• Is risk discipline aligned with bank’s strategy?
• How integrated is risk management with the bank’s overall
operating philosophy?

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Risk Positioning Sub-factors

¾ Corporate governance
„ Controls and risk management
„ Financial reporting transparency
„ Credit risk concentration
„ Liquidity management
„ Market risk appetite

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Corporate Governance – Key Factors

„ Ownership & organizational complexity

„ Key man risk
„ Insider and related party risks

„ If an individual factor is not scored as a D or E,

the factor is neutral
– And does not contribute positively or negatively to indicative BFSR

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Ownership & Organizational Complexity

„ Can be more difficult for board to exert objective,

independent oversight if:
– Ownership is concentrated,
– Voting control is concentrated in the hands of shareholders with a
relatively small economic interest, and/or
– Ownership structures are complex
• e.g. multiple, minority ownership interests or pyramid structures

„ Large shareholders, particularly family owners,

can encourage long-term decision-making
– But it can be difficult to manage potential conflicts between large
owners & minority shareholders
– Task made more difficult if controlling shareholders hold key
management positions

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Ownership & Organizational Complexity

„ Factors leading to a D score

– Complex ownership structure or
– > 50% ownership by an individual legal person (including the
government) or family
„ Factors leading to an E score
– Complex or private ownership as described for “D”, plus either:
• Complex organizational structure that is hard for board or
outsiders to understand, or
• Family members or government officials dominate management

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Key Man Risk

„ Is the bank is highly dependent on a single executive or

group?
– Could this loss of talent adversely affect the bank’s fundamentals?
„ Factors contributing to a D score
– Management lacks depth (e.g. 1-2 individuals dominate
management with no apparent successor or succession planning),
OR
– Dominance of a single generation within senior management
„ Factors contributing to an E score
– Lack of management depth, AND
– Dominance of a single generation in senior management

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Insider and Related Party Risks
„ Related party (RPT) loans
– Strong independent credit approval process is essential to a
bank’s creditworthiness
– Significant extensions of credit to insiders may indicate that
underwriting standards are being circumvented (or not being
applied consistently)
– Related party loans can also create credit concentrations that may
be harder to handle than other concentrations
– Related party loans to controlling shareholders, bank executives or
persons/entities related to them are of particular concern
„ Low board independence increases bank’s risk profile

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Insider and Related Party Risks
„ Factors contributing to a D score
– Total RPT loans between 25% & 40% of Tier 1 capital, OR
– Less than 25% of supervisory board is independent
„ Factors contributing to an E score
– Total RPT loans > 40% of Tier 1 capital, OR
– No one on supervisory board is independent

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 Moody’s Governance Analysis is
Broader than BFSR Scores

„ BFSR scorecard for “governance component” of 2nd

factor limited to 3 key indicators
„ Risk governance also considered as part of risk
management assessment (RMA)
– Considered as part of analysis of 2nd factor
„ Indicative BFSR score can be adjusted
– as part of rating committee process to take into account qualitative
factors (including governance)
„ Ongoing governance analysis is more expansive:
– Executive pay / director pay
– Board practices / whether outside directors actively involved
– Director skills
– Director independence
– Ownership dynamics
– More nuanced look at executive succession

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 Risk Management Assessment (RMA)
Also Considers Governance

„ Four pillars of RMA methodology

¾ Risk governance at board & senior management level
¾ Dynamic involvement of board in setting firm’s risk appetite
¾ Chief risk officer reports directly to CEO and board
¾ Risk management holds veto power
¾ Effective alignment of risk with corporate & financial
objectives
– Risk management
– Risk measurement
– Risk infrastructure

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Some Moody’s
Publications on
Governance

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Governance Special Comments: General

„ Assessing Corporate Governance in Family-Controlled Companies from a Debt Holder

Perspective, January 2008 (106287)
„ U.S. Corporate Governance: Reviewing 2007, Previewing 2008, December 2007
(106273)
„ Analyzing Unexpected CEO Departures and Severance Payments for Signs of Weak
Governance, December 2007 (105930)
„ Western European Executive Pay Disclosure Trends Bode Well for Better Credit
Analysis, December 2007 (105837)
„ Credit Implications of Corporate Governance in Private Equity-Owned Companies,
November 2007 (105808)
„ DOJ Investigations into Rated Issuers Can Have Significant Negative Ratings
Implications, July 2007 (103761)
„ Expanding U.S. Shareholder Power Increases Potential Credit Risk to Bondholders,
June 2007 (103598)
„ Short-Term Shareholder Activists Degrade Creditworthiness of Rated Companies,
June 2007 (103433)
„ A User’s Guide to the SEC’s New Rules for Reporting Executive Pay, April 2007
(102762)
„ U.S. Directors May Have To Confront Investor Demands To Rethink Executive Pay,
January 2007 (101676)
„ Update: 11 Issuers See Rating Actions Linked to Option Timing Probes, November
2006 (100524)

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Governance Special Comments: General

„ Do Boards Of Directors Need More Direct Staff Support, October 2006 (100417)
„ Criteria for Assessing Director Independence, October 2006 (100302)
„ Best Practices In Audit Committee Oversight of Internal Audit, October 2006
(99909)
„ Best Practices for a Board’s Role in Risk Oversight, August 2006 (98545)
„ Board Leadership: A Positive View on Non-executive Chairs and Lead Directors,
August 2006 (98557)
„ Stock Option-Timing: Scrutiny and Risks Increase, July 2006 (98494)
„ U.S. Executive Pay Structure and Metrics, June 2006 (97887)
„ Stock Options “Backdating”, June 2006 (97760)
„ The Downside of Incentive Pay for Directors, April 2006 (97174)
„ Assessing Corporate Governance As A Ratings Driver For North American Financial
Institutions, April 2006 (97279)
„ Lessons Learned in Moody’s Experience in Evaluating Corporate Governance at Major
North American Issuers, April 2006 (97104)
„ Moody’s Response to Rated Companies Receiving SEC Wells Notices, October 2005
(94627)
„ Moody’s Findings on Corporate Governance in the United States and Canada, October
2004 (89113)

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Governance Special Comments: General

„ Stock Options “Backdating”, June 2006 (97760)

„ The Downside of Incentive Pay for Directors, April 2006 (97174)
„ Assessing Corporate Governance As A Ratings Driver For North American Financial
Institutions, April 2006 (97279)
„ Lessons Learned in Moody’s Experience in Evaluating Corporate Governance at Major
North American Issuers, April 2006 (97104)
„ Moody’s Response to Rated Companies Receiving SEC Wells Notices, October 2005
(94627)
„ Moody’s Findings on Corporate Governance in the United States and Canada, October
2004 (89113)

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Special Comments: Governance of Financial Firms

„ Key Man Risk in Private Equity Firms and Hedge Funds is a Potential Credit Risk for
Bondholders, December 2007 (106058)
„ North American Insurers Face Three Significant Governance Risks, June 2007
(103269)
„ All Change at the Top - The Rating Implications of Future CEO Changes in the U.S.
Banking Sector, July 2006 (98179)
„ Evaluating The Rating Significance Of Regulatory Actions Against U.S. Banks, April
2006 (97230)
„ No Assurance of Good Governance: Observations on Corporate Governance in the
U.S. Insurance Sector, October 2005 (94705)
„ Don’t Bank on Strong Governance: Observations on Corporate Governance in US
Banks, August 2005 (93743)

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 Other Documents
„ Bank Financial Strength Ratings: Global Methodology, February 2007 (102151)
„ Incorporation of Joint-Default Analysis into Moody’s Bank Ratings: A Refined
Methodology, March 2007 (102639)

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Acknowledgments and Contacts

„ This presentation is based on the work of, and prepared with the
assistance of, the Corporate Governance Specialist Team at Moody’s
Investors Service
– Mark LaMonte, Senior Vice President and Team Leader
(mark.lamonte@moodys.com)
– Drew Hambly, Assistant Vice President-Analyst
– Christian Plath, Assistant Vice President-Analyst

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