Basics of Credit Rating

Credit risk involves default risk, recovery risk, exposure risk, and maturity. Previously, lenders and financial institutions have depended on external credit ratings for calculating the relative creditworthiness of a specific issue. Ratings were initially introduced in a business context, e.g., bond markets. These ratings were rendered by popular rating agencies such as Moody’s, Standard and Poor’s (S&P), and Fitch that render separate and independent risk assessments. Rating agencies successfully play the role of information intermediary between the investors and borrowers. The rating agencies’ are generally financed by commission fees.

Ratings are an outcome of a thorough analysis of public and private information, and involves a quantitative analysis, which looks at

• the debt structure
• financial statement
• balance-sheet data
• sector information

The qualitative analysis assesses,

• management quality
• competitive position
• growth prospects

Data is gathered from public sources, and from the rated company itself during visits and meetings with the senior management. The credit rating is given by a rating committee with experts on various subjects, and is communicated with the senior management of the issuer. After the initial rating assigned to the borrower, the rating is re-evaluated at every interval by the agency until the rating is withdrawn.The primary purpose of ratings was to differentiate between investment grade and non-investment-grade debt securities. The first credit ratings tried to produce an ordinal calculation of the default or expected loss risk of the issued security.Now, credit ratings are aligned to issuer default risk and issue loss or recovery risk.

The list of credit ratings given by different rating agencies is provided in a table at the beginning of this chapter. The notion of expected loss (PD × LGD) risk is still pertinent in current business scenarios. The Basel II Capital Accord heavily emphasizes on the importance of the role of external credit assessment institutions (ECAI) as rating changes have a direct effect on capital market’s equity prices, bond prices and risk management strategies. Although external ratings cover a wide range of variables across broad geographical areas, there are many counterparts in the banking books that do not yet have an external rating. The Basel II Capital Accord has requested financial institutions to establish an internal rating system for regulatory capital calculations.

Rating and scoring systems

Both credit scores and credit ratings provide a credit risk assessment. When scores are gathered into a single risk classes, the result of the score is a “rating”. ‘Score’ is specifically used in the retail context where large customer databases are scored automatically through statistical scoring systems. ‘Ratings’ are allotted to security issue and they consider both objective and subjective variables. Ratings are the outcome of a manual procedure that could take days to weeks to accomplish.

For internal purposes, score systems and bureau scores are very helpful. Conversely, external credit ratings are made public by the rating agencies for investors. The rated firms publish their ratings to raise capital and better their funding strategy. Large rated companies need to show a well developed financial management to raise capital from the capital markets, like from the bond markets. Because of this, issue ratings normally concern publicly traded debt. Individuals, on the other hand, do not publish their scores and is considered private. Bank loans also do not require or request for the rating. While agency ratings are made public, internal credit ratings and scores are kept concealed from public use.

To ensure rating consistency, internal ratings are based upon mathematical methods that provide a score which is again used for the final internal rating decision. The decision to override mathematical rating depends on the written internal rules and policies. In addition to the larger impact of subjective elements, internal ratings are systematically the same as internal scores. As internal ratings are used on asset classes parallel to those externally rated, the scale of internal ratings is mostly similar to those of external ratings reported.

Ratings are normally performance ratings that present an ordinal risk calculation.Using the ratings published by the agencies, investors decide what price should be set. Scores aid numerous functions, application, and behavioural scoring making it the most significant details for retail customers. For retail customers, individual ratings are not required for Basel II capital calculations, it is allowed to measure the risk on homogeneous pools of customers.

Internal scores and ratings serve a purpose for internal risk management and regulatory capital calculations. Firms use external ratings for the same reason and further for benchmarking their internal ratings with external ratings. External ratings are available for large companies, banks and sovereigns. It aids various purposes in finance such as,

• investment decisions
• pricing
• portfolio management.