Commercial Credit Risk Management
Content
Commercial Credit Risk Management
Commercial credit risk is the largest and most elementary risk faced by many banks, and it is a major risk for many other kinds of financial institutions and corporations as well.
many uncertain elements are involved in determining both how likely it is that an event of default will happen and how costly default will turn out to be if it does occur.
Some of the newest approaches employ equity market data to track the likelihood of default by public companies, while other approaches have been developed to assess credit risk at the portfolio level using mathematical and statistical modeling
Traditional approach
Creditrisk assessments within an overall framework known as a credit rating system
To make a credit assessment
analysts must take into consideration many complex attributes of a firm financial and managerial, quantitative and qualitative.
They must ascertain the financial health of the firm, determine whether earnings and cash flows are sufficient to cover any debt obligations, analyze the quality of the firm s assets, and examine its liquidity position.
In addition, analysts must take into account the nature of the industry to which the potential client belongs, the status of their new client within that industry, and the potential effect of macroeconomic events on the firm (including any country risks, such as a political upheaval or currency crisis).
A credit rating system is simply a way of organizing and systematizing all these procedures so that credit analysts across a firm arrive at ratings that are rational, coherent, and comparable.
We ll look first at how credit rating agencies (key players in the development of modern ratings) arrive at their public credit ratings of large corporations.
Then we ll take a look at how banks arrive at their own private internal ratings of firms, large and small, that lack a public credit rating.
Internal risk rating systems are one of the banking industry s oldest and most widely used credit-risk measurement tools, but practices are changing fast as a result of both regulatory and competitive pressures. Internal rating systems allow the analysis of thousands of borrowers within a consistent framework and permit comparisons across the entire loan portfolio.
PURPOSE OF INTERNAL RISK RATING SYSTEMS (IRRS)
Setting limits and acceptance or rejection of new transactions. The strength of the rating awarded to an entity or transaction is likely to play a key role in the decision to accept or reject a particular transaction. Credit-risk limits are often set in terms of rating categories. Also, concentration limits by name, industry, and country are established and revised annually by the senior risk committee of the bank.
Monitoring of credit quality
Ratings should be reviewed periodically at least once a year or if a specific event justifies the revision of the credit assessment of a borrower. Credit migration is a critical component in monitoring the credit quality of the loan portfolios of banks.
Attribution of economic capital
Best-practice institutions will have a risk adjusted return on capital (RAROC) system in place to assess the contribution to shareholder value of the firm s activities and portfolios. Internal ratings are key input in the economic capital allocation process to credit portfolios.
Risk adjusted return on capital (RAROC)
RAROC is defined as the ratio between the Expected Return and Economic Capital. The expected return is the return minus expected losses. Economic Capital is the money which is needed to secure the survival in a worst case scenario. This is a function of the market, credit and operational risks and is often calculated by Var.
Adequacy of loan loss reserves
Both regulators and management use the distribution of portfolio quality, as measured by internal ratings, to judge the adequacy of the financial accountingbased reserve for loan losses and the provision for losses in the current accounting period.
Adequacy of capital
Again, both regulators and management, and also rating agencies, use the portfolio risk profile, as measured by internal ratings, to judge the fundamental creditworthiness of the institution as a whole.
Pricing and trading of loans
Internal ratings are key inputs for credit portfolio models from which the risk contribution of each facility in a credit portfolio can be derived. In turn, these risk contributions help determine the minimum spread that an institution should charge on a credit facility in order to factor in the cost of credit risk. Failing to take account of the relative cost of extending credit destroys shareholder value
RATING AGENCIES
The External Agency Rating Process
The issuance of bonds by corporations is a twentieth-century phenomenon. Soon after bonds began to be issued, companies such as Moody s (1909), Standard & Poor s (1916), and other agencies started to offer independent assessments of how likely it was that particular bonds would repay investors in the way they were intended to do.
Over the last 30 years, the introduction of new financial products has led to the development of new methodologies and criteria for credit rating: Standard & Poor s (S&P) was the first rating company to rate mortgage-backed bonds (1975), mutual funds (1983), and asset-backed securities (1985).
A credit rating is not, in general, an investment recommendation for a given security. When rating a security, a rating agency focuses more on the potential downside loss than on the potential upside gain.
In the words of S&P
A credit rating is S&P s opinion of the general creditworthiness of an obligor, or the creditworthiness of an obligor with respect to a particular debt security or other financial obligation, based on relevant risk factors.
In Moody s words
a rating is, an opinion on the future ability and legal obligation of an issuer to make timely payments of principal and interest on a specific fixed income security.
S&P and Moody s have access to a corporation s internal information, and since they are considered to have expertise in credit rating and are generally regarded as unbiased evaluators, their ratings are widely accepted by market participants and regulatory agencies.
Financial institutions, when required by their regulators to hold investment-grade bonds, use the ratings of credit agencies such as S&P and Moody s to determine which bonds are of investment grade.
There are two main classes of ratings
With issuer credit ratings, the rating is an opinion on the obligor s overall capacity to meet its financial obligations. In the issuer credit rating category are counterparty ratings, corporate credit ratings, and sovereign credit ratings.
Issue-specific credit ratings
Another class of rating is issue-specific credit ratings. In this case, the rating agency makes a distinction, in its rating system and symbols, between long-term and short-term credits. The short-term ratings apply to commercial paper (CP), certificates of deposit (CD), etc. The rating is of a specific issue, and not the issuer.
In rating a specific issue, the attributes of the issuer, as well as the specific terms of the issue, the quality of the collateral, and the creditworthiness of the guarantors, are taken into account.
The rating process includes quantitative, qualitative, and legal analyses. The quantitative analysis is mainly financial analysis and is based on the firm s financial reports. The qualitative analysis is concerned with the quality of management; it includes a thorough review of the firm s competitiveness within its industry as well as the expected growth of the industry and its vulnerability to business cycles, technological changes, regulatory changes, and labor relations.
Process of rating an industrial company
The analyst works through sovereign and macroeconomic issues, industry outlook, and regulatory trends, to specific attributes (including quality of management, operating position, and financial position), and eventually to the issue-specific structure of the financial instrument.
The assessment of management, which is subjective in nature, investigates how likely it is that management will achieve operational success and takes the temperature of its tolerance for risk. The rating process includes meetings with the management of the issuer to review operating And financial plans, policies, and strategies.
All the information is reviewed and discussed by a rating committee with appropriate expertise in the relevant industry, which then votes on the recommendation. The issuer can appeal the rating before it is made public by supplying new information. The rating decision is usually issued four to six weeks after the agency is asked to rate a debt issue.
Moody s Rating Analysis of an Industrial Company
Issue Structure Company Structure Operating/Financial Position Management Quality Industry/Regulatory Trends Sovereign/Macroeconomic Analysis
Usually the ratings are reviewed once a year based on new financial reports, new business information, and review meetings with management. A credit watch or rating review notice is issued if there is reason to believe that the review may lead to a credit rating change. A change of rating has to be approved by the rating committee.
Credit Ratings by S&P and Moody s
Standard & Poor s (S&P) is one of the world s major rating agencies, operating in more than 50 countries. Moody s operates mainly in the United States but has many branches internationally
Issues rated in the four highest categories (i.e., AAA, AA, A, and BBB for S&P and Aaa, Aa, A, and Baa for Moody s) are generally considered to be of investment grade.
Some financial institutions, for special or approved investment programs, are required to invest only in bonds or debt instruments that are of investment grade. Obligations rated BB, B, CCC, CC, and C by S&P (Ba, B, Caa, Ca, and C by Moody s) are regarded as having significant speculative characteristics. BB (Ba in Moody s) is the least risky, and C is the most risky.
S&P uses plus or minus signs to modify its AA to CCC ratings in order to indicate the relative standing of a credit within the major rating categories. Similarly, Moody s applies numerical modifiers 1, 2, and 3 in each generic rating classification from Aa through Caa. The modifier 1, for example, indicates that the obligation ranks at the higher end of its generic rating category; thus B1 in Moody s rating system is a ranking equivalent to B! in S&P s rating system.
How accurate are agency ratings
based on data from the period 1981 to 2004 the lower the rating, the higher the cumulative default rates. The Aaa and Aa bonds experienced very low default rates; after 10 years, less than 1 percent of the issues had defaulted. Approximately 35 percent of the B-rated issues, however, had defaulted after 10 years.
Historical data seem to offer a general validation of agency ratings. But they are useful for another reason: they allows risk analysts to attach an objective likelihood of default to any company that has been rated by an agency or that has been rated by banks in a manner thought to be equivalent to an agency rating.
While the major rating agencies use similar methods and approaches to rate debt, they sometimes come up with different ratings for the same debt investment. Academic studies of the credit rating industry have shown that only just over half of the firms rated AA or Aa and AAA or Aaa in a large sample were rated the same by the two top agencies. The same study found that smaller agencies tend to rate debt issues higher than or the same as S&P and Moody s; only rarely do they award a lower rating
DEBT RATING AND MIGRATION
Bankruptcy, whether defined as a legal or an economic event, usually marks the end of a corporation in its current form. It is a discrete event, yet it is also the final point in a continuous process the moment when it is finally recognized that a firm cannot meet its financial obligations.
credit agencies do not focus simply on default. At discrete points in time, they revise their credit ratings of corporate bonds. This evolution of credit quality is very important for an investor holding a portfolio of corporate bonds.
INTERNAL RISK RATING
banks are in the business of lending money to a very wide spectrum of companies, not just those that issue public debt (and that therefore find it useful to invest in gaining a credit rating). Many smaller and private companies are not even listed on a public stock exchange, so that much of the financial data that can be gathered about them are of unproven quality.
Typically, a bank IRRS assigns two kinds of ratings. First, it assigns an obligor default rating (ODR) to each borrower (or group of borrowers) that identifies the borrower s probability of default. Second, it assigns a loss given default rating (LGDR) to each available facility, independently of the ODR, that identifies the risk of loss from that facility in the event of default on the obligation.
To understand the fundamental difference between these two kinds of rating, let s consider the key concept of expected loss. The expected loss of a particular transaction or portfolio is the product of the amount of credit exposure at default (say, $100) multiplied by the probability of default (say, 2 percent) for an obligor (or borrower) and the loss rate given default (say, 50 percent) in any specific credit facility. In this example, the expected loss is $100 * 0.02 * 0.50 = $1.
The ODR represents simply the probability of default by a borrower in repaying its obligation in the normal course of business. The LGDR, on the other hand, assesses the conditional severity of the loss, should default occur. The severity of the loss on any facility is considerably influenced by whether the bank has put in place risk mitigation tools such as guarantees, collateral, and so on.
As well as identifying the risks associated with a borrower and a credit facility, an IRRS also provides a key input for the capital charges used in various pricing models and for riskadjusted return on capital (RAROC) systems
Steps in the IRRS
FINANCIAL ASSESSMENT (STEP 1)
Introduction
This step formalizes the thinking process of a good credit analyst (or good equity analyst), whose goal is to ascertain the financial health of an institution. The credit analyst might begin by studying the institution s financial reports to determine whether the earnings and cash flows are sufficient to cover the debt repayments. The credit analyst will study the degree to which the trends associated with these financials are stable and positive.
The credit analyst will also want to analyze the company s assets to determine whether they are of high quality, and to make sure that the obligor has substantial cash reserves (e.g., substantial working capital5). The analyst will also want to examine the firm s leverage. Similarly, the credit analyst will want to analyze the extent to which the firm has access to the capital markets, and whether it is able to borrow the money that it will need to carry out its business plans.
The rating should reflect the company s financial position and performance and its ability to withstand any financial setbacks.
Procedure
The three main assessment areas, are (1) earnings and cash flow; (2) asset values, liquidity, and leverage; and (3) financial size, flexibility, and debt capacity.
A measure for earnings and cash flow would take into account interest coverage expressed in terms of key accounting ratios for example, the ratio of earnings before interest and taxes (EBIT) to interest expense and the ratio of earnings before interest, taxes, depreciation, and amortization (EBITDA) to interest expense
The analysis would emphasize the current year s performance, with some recognition of the previous few years as appropriate. When assessing companies in cyclical industries, the analyst should adjust the financial results and key ratios so that the cyclical effect is incorporated.
A measure for leverage might be ratios of debt to net worth such as total liabilities to equity or (total liabilities minus debt) to equity.
When assessing the financial size, flexibility, and debt capacity category, the size of the market capitalization will be an important factor.
The analyst would calculate a risk rating for each of the three assessment areas and then arrive at an assessment of the best overall risk rating. This is the initial obligor rating.
Industry Benchmarks
The analysis of a firm s competitive position and operating environment helps in assessing the firm s general business risk profile. This profile can be used to calibrate quantitative information drawn from the financial ratios for the firm,
A company with an excellent business in a growing or stable sector can assume more debt than a company with less glowing prospects
Management and Other Qualitative Factors (Step 2)
This second step considers the impact on an obligor rating of a variety of qualitative factors, such as discovering unfavorable aspects of a borrower s management. Step 2 analysis may bring about a downgrade if standards are not acceptable.
A typical Step 2 approach would require such activities as examining day-to-day account operations, assessing management, performing an environmental assessment, and examining contingent liabilities
For example, in the case of day-to-day account operations, is the firm s financial reporting on a timely basis and of good quality? Does the firm satisfactorily explain any significant variations from projections? Are credit limits and terms respected? Does the company honor its obligations to creditors?
In the case of a management assessment, the analyst might check that management skills are sufficient for the size and scope of the business. Does management have a record of success and appropriate industry experience? Does management have adequate depth (for example, are succession plans in place)? Is there an informed approach to identifying, accepting, and managing risks?
Does management address problems promptly, exhibiting the will to take hard decisions as necessary, with an appropriate balance of short- to long-term concerns? Is management remuneration prudent and appropriate to the size, financial strength, and progress of the company?
Industry Ratings Summary (Step 3a)
The importance of interaction between an industry rating and the relative position of the borrower within its industry. Experience has shown that poorer-tier performers in weak, vulnerable industries are major contributors to credit losses.
using an industry assessment (IA) ratings scheme for each industry. To calculate the industry assessment, the analyst first assigns a score of 1 (minimal risk) to 5 (very high risk) for each of a set of, say, eight criteria established by the bank. For example, each industry might be described in terms of its competitiveness, trade environment, regulatory framework, restructuring, technological change, financial performance, long-term trends affecting demand, and vulnerability to macroeconomic environment.
Tier Assessment (Step 3b)
The criteria and process used to assess industry risk can often be reapplied to determine a company s relative position (say, on a scale of tiers 1 to 4) within an industry. A business should be ranked against its appropriate competition. That is, if the company supplies a product or service that is subject to global competition, then it should be ranked on a global basis. If the company s competitors are by nature local or regional, as is the casefor many retail businesses, then it should be ranked on that basis
In a four-tier system, tier 1 players are major players with a dominant share of the relevant market (local, regional, domestic, international, or niche). They have a diversified and growing customer base and have low production costs that are based on sustainable factors (such as a diversified supplier base, economies of scale, location and resource availability, continuous upgrading of technology, and so on). Such companies respond quickly and effectively to changes in the regulatory framework, trading environment, technology, demand patterns, and macroeconomic environment.
Tier 2 players are important or above-average industry players with a meaningful share of the relevant market (local, regional, domestic, international, or niche). Tier 3 players are average (or modestly below average) industry players, with a moderate share of the relevant market (local, regional, domestic, international, or niche). Tier 4 players are weak industry players with a declining customer base. They have a high cost of production as a result of factors such as low leverage with suppliers, obsolete technologies, and so on.
Industry/Tier Position (Step 3c)
This final part of the third step (Step 3c) combines the assessments of the health of the industry (i.e., the industry rating) and the position of a business within its industry (i.e., the tier rating). While the tier rating can be lowered if the industry/tier assessment is weak, it will not be raised if this position is strong. The process reveals the vulnerability of a company, particularly during recessions. Low-quartile competitors within an industry class almost always have higher risk (modified by the relative health of the industry).
Financial Statement Quality (Step 4)
This fourth step recognizes the importance of the quality of the financial information provided to the analyst. This includes consideration of the size and capabilities of the accounting firm compared to the size and complexities of the borrower and its financial statements. Again, the rating should not be raised even if the result is good; the point of this step is to define the highest possible rating that can be obtained.
Country Risk (Step 5)
This fifth step adjusts for the effect of any country risk. Country risk is the risk that a counterparty or obligor will not be able to pay its obligations because of crossborder restrictions on the convertibility or availability of a given currency. It is also an assessment of the political and economic risk of a country. Country risk exists when more than a prescribed percentage (say 25 percent) of the obligor s (gross) cash flow (or assets) is located outside of the local market.
Country risk may be mitigated by hard currency cash flow received or earned by the counterparty. Hard currency cash flow refers to revenue in a major (i.e., readily exchanged) international currency (primarily U.S. and Canadian dollars, sterling, euro, and Japanese yen). Again, Step 5 limits the best possible rating. For example, if the client s operation has a country rating in the fair category, then the best possible obligor rating might be limited to 5.
Comparison to External Ratings (Step 6)
When the obligor is rated by an external rating agency or when it is included in the database of an external service providing default probability estimates, such as KMV, the preliminary ODR produced in Step 5 is compared to these external ratings. The intent is not to align the internal rating with that of an external agency but to ensure that all appropriate risk issues have been factored into the final ODR.
When the ODR differs substantially from the external rating, then the rater should review the assessment on which the rating process is based (Steps 1 to 5). If the comparison suggests that important risk factors were overlooked or underestimated in the preliminary analysis, then these factors should be incorporated in the final ODR by revising Steps 1 through 5.
This step can be viewed as a sanity check to validate the internally derived ODR and ensure the completeness of the analysis followed in Steps 1 through 5.
Loan Structure (Step 7)
The risk rating process (Steps 1 through 6) assumes that most credits have an appropriate loan structure in place. If so, Step 7 has no impact on the ODR. However, if the loan structure is not sufficiently strong and is viewedas having a negative impact on the risk of default of the obligor, then a downgrade is required. As a general rule, the weaker the preliminary ODR concluded in Step 6, the more stringent the loan structure should be to be regarded as appropriate.
The components of the loan structure that may affect default risk are the financial covenants, the term of the debt, its amortization scheme, and change-of-control restrictions. For example, in the case of high-risk companies, financial ratio requirements should be progressive and should fit tightly with the company s own forecasts. In addition, significant amortization of debt over the tenure of the facilities should be imposed, and nonmerger restrictions should be put in place.
LOSS GIVEN DEFAULT RATING (LGDR)
Step 8 assigns a loss given default rating to each facility. This rating is determined independently of default probabilities. The probability of default and the loss experienced in the event of default are separate risk issues and therefore should be looked at independently. Typically, each LGDR is mapped to an LGD factor, i.e., a number between 0 and 100 percent, with 0 percent corresponding to the case of total recovery and 100 percent to the situation where the creditor loses all the amount due. The LGD should be calculated net of the recovery cost.
Different evaluation methods are used depending on whether the credit is unsecured or is secured by third-party support or collateral. The presence of security should mitigate the severity of the loss given default for any facility. The quality and depth of security varies widely and will determine the extent of the benefit in reducing any loss.
When the credit is secured by a guarantor, the analyst must be convinced that the third party/owner is committed to ongoing support of the obligor. When a facility is protected by collateral, the collateral category should reflect only the security held for the facility that is being rated.
Collateral can have a major effect on the final LGDR, but the value of collateral is often far from straightforward. The value of securities used as collateral is often a function of movements in market rates. In the most worrying situation, collateral values tend to move down as the risk ofobligor default rises. For example, real estate used as collateral for a loan to a property developer has a strong tendency to lose its value during a property downturn the moment in the sector cycle when a property developer is most likely to default.
the new Basel Capital Accord (Basel II) puts a special emphasis on the internal rating based approach for creditrisk attribution. In the future, many banks will be able to use their internal ratings to calculate the amount of regulatory risk capital they must put aside for key credit risks. But to do so, banks will have to prove that their internal rating system meets certain standards.
The history of the ratings industry began in the USA in the late 19th century with the building of the country s railway system. The debt instruments issued by the various railways were a tempting target for risk classification for investors. The precursors of bond rating agencies were the mercantile credit agencies, which rated merchants' ability to repay their financial obligations.
In 1841, Louis Tappan established the first mercantile credit agency in New York. Robert Dun, subsequently,acquired the agency and published its first ratings guide in 1859. A similar mercantile rating agency was formed in 1849 by John Bradstreet, who published a ratings book in 1857. In 1933, the two agencies were consolidated into Dun and Bradstreet, which later acquired Moody's Investors Service (in 1962).
Gradually, the mercantile rating agencies began providing ratings on other financial instruments and securities like bonds, bank deposits and commercial papers. Moody s began by rating railroad bonds (1909), and a year later, extended its ratings activity to utility and industrial bonds.
The Fitch Publishing Company was established in 1924. Standard & Poor s (S&P) was formed with the merger of Poor's Publishing Company and Standard Statistics Company in 1941.
The major agencies were either independent or owned by nonfinancial companies. Moody's, a subsidiary of Dun and Bradstreet, dominated the market for commercial credit ratings. Standard and Poor's was a subsidiary of McGraw-Hill, a major publishing company with a strong business information focus. Fitch, initially a publishing company, was bought by an independent investor group in 1989.
The three primary rating agencies are as follows: 1. Moody s Investor Service 2. Standard & Poor s 3. Fitch
Moody s and S&P are generally considered the most influential because they have the widest geographical coverage.
The agencies operate without government mandate, and have remained independent from the investment community. It is because of their independence and reputation for being objective that their opinions are accepted as credible by the investment community.
Rating agencies generate their revenues from two primary sources:
1. Fees from issuers that solicit ratings for their securities, which consist of both per-issue fees and annual fees. The amount of the fee depends on the type and size of security being rated and on the total number of securities of the issuer already rated by the agency. For bonds and preferred stock, per-issue fees for both Moody s and S&P have a minimum of $25,000 $30,000 and a maximum of 225,000 $250,000. Annual fees range from $12,500 to $15,000.
2. The sale of research, software, and other proprietary information.
At first glance, it may seem unusual that rating agencies are able to charge issuers to have their credit quality scrutinized. In particular, why should a firm pay to get a low or disappointing rating? The alternative, however, is to attempt to issue the security with no rating, which is tantamount to signaling the very poorest of investment quality.
Over the years, the rating agencies have established a reputation as providing reliable assessments of risk in the capital markets so much so, that a low rating is better than no rating in terms of the price paid for a new issue and the level of demand for the issue. On the flip side, receiving a high rating works strongly in an issuer s favor by signaling to the market that the issue deserves favorable pricing.
Such signaling would not be credible in the capital markets without the services of a highly reputable third party whose livelihood depends directly on its reputation for accuracy and independence.
Rating Categories
Ratings are constructed to represent the risk of default; that is, a high (low) rating implies a low (high) probability of default. Default refers to any event that results in the issuer s breaching its financial contract.
Large companies with strong and stable cash flows are likely to be rated higher than small companies with more volatile cash flows.
Investment grade refers to the safest levels of financial securities. Investment-grade securities have historically exhibited relatively low rates of default.
Speculative grade, or noninvestment grade, refers to the riskier securities. Debt rated BB (Ba for Moody s) or below is noninvestment grade, and is sometimes referred to as high yield or junk. Default rates among these classes of securities are comparatively high.
Within the major rating categories (AA, A, etc.), credit ratings are often modified to show relative standing within a category. Moody s uses numbers 1, 2, and 3, while S&P and Fitch use plus (+) and minus ( ) signs.
For example, the three tiers of the triple-B category are as follows:
Moody's Baa1 Baa2 Baa3 S&P BBB+ BBB BBBFitch BBB+ BBB BBBIntermediate
Notching
Rating agencies recognize the relative risk of securities issued by the same firm by notching the issues relative to each other. Debt obligations have varying degrees of risk, depending on their priority in a company s capital structure.
For example, senior debt has priority over subordinated debt in bankruptcy and will therefore receive a higher rating. Similarly, secured debt will receive a higher rating over unsecured debt because of its senior claim.
A specific example is CSX Corporation, a transportation company headquartered in Richmond, Virginia, which received a Moody s rating for its equipment trust certificates (secured debt) of A1, a rating of Baa2 for its senior unsecured debt, and a Baa3 rating for its subordinated debt. Its subordinated debt is said to be rated one notch below its senior debt.
Rating Outlooks
Rating agencies recognize the possibility that future performance will deviate from initial expectations. Rating outlooks address this matter by focusing on scenarios that could result in a rating change. For example, a security could be placed on Moody s Review or S&P s CreditWatch because of a merger announcement if it has the potential to affect, either adversely or positively, the ability of an issuer to meet its obligations. Rating reviews are normally completed within 60 to 90 days or as soon as the situation has been resolved.
The Rating Process
The first step in the process is for the rating agencies to meet with company management. The purpose of this meeting is to discuss the proposed offering, the company s operating and financial performance and outlook, and a host of other factors that might affect the rating. The company s chief financial officer is the main participant in these discussions, with the chief executive officer participating in any strategy discussions.
Following this meeting, the rating agencies assign a team of individuals to analyze the transaction. This team includes the relevant industry analyst and a product analyst if the security to be rated is specialized. The team reviews the offering documents, financial statements, and management s presentation, which includes the terms of the proposed offering, use of proceeds, historical and pro forma financial analysis, competitive analysis, capital-expenditure plans, etc. The rating agency s analysis, projections, and opinions may vary from those of the company s management or their investment bankers.
When the rating team has finished its analysis, a recommendation is made to an internal rating committee that votes on the proposed rating. Once the rating is determined, the company is notified and the rationale behind the rating is explained. A rating is often assigned within two weeks, depending on the nature of the proposed transaction, the current demand for ratings by other issuers, and the urgency of the company s request.
Both Moody s and S&P allow the company to respond to the rating before it is released to the media, which gives the company the opportunity to appeal and present additional data supporting a higher rating. After the final rating is assigned, the industry analyst tracks the company s performance and adjusts the rating, as appropriate, over time.
Provided there are no specific concerns or additional issuances of securities, the rating agency typically conducts formal quarterly reviews and meets with management at least once annually to stay current with the company s development.
Rating Methodology
Assigning a rating involves a comprehensive review and analysis of a number of important categories of information with respect to the issue or issuer.
Because ratings are relative measures of default risk, it is not surprising that companies with stronger financial measures have higher ratings, on average.
The Role of Ratings in the Capital Markets
Ratings provide benefits to both issuers and investors. Issuing companies with an investmentgrade rating enjoy wide and relatively inexpensive access to capital. Many investors, such as insurance companies, can invest only a limited percentage of funds in either speculativegrade or unrated securities. Thus, companies that have investment-grade ratings expand their universe of potential investors considerably.
For investors
For investors, ratings primarily reduce uncertainty. Less uncertainty encourages market growth and greater efficiency and liquidity. Ratings also widen investors horizons by providing expert analysis of issues or issuers that can be difficult for even the most sophisticated investors to examine. Finally, ratings provide benchmark investment limits, so that a pension fund, for example, can manage its risk by stipulating a limit on the percentage of its assets that can be invested in securities below a certain rating.
Standard & Poor's Sovereign Credit Ratings: Scales and Process
S&P s long-term credit-rating scale establishes a lettergrade hierarchy.
Ratings include AAA ( extremely strong repayment capacity); AA ( very strong ); A ( strong ); BBB ( adequate ); BB ( less vulnerable ); B ( more vulnerable ); CCC ( currently vulnerable );
CC ( currently highly vulnerable ); R ( under regulatory supervision owing to its financial condition ); SD ( selective default ); D ( default ); and NR ( not rated ).
Ratings of BBB and above are considered investment grade, while ratings of BB and below are noninvestment grade, or speculative grade.
Short-term credit ratings
Short-term credit ratings also consist of letter grades, but according to a simpler scale including A-1 ( strong repayment capacity); A-2 ( satisfactory ); A-3 ( adequate ); B ( more vulnerable ); C ( currently highly vulnerable );
R ( under regulatory supervision ); SD ( selective default ); D ( default ); and NR ( not rated ).
Rating Outlook
A rating Outlook assesses the potential direction of a long-term credit rating over the intermediate to longer term, addressing any changes in the economic and/or fundamental business conditions. Outlook categories include Positive (rating may be raised ); Negative ( may be lowered ); Stable ( not likely to change ); Developing ( may be raised or lowered ); and NM ( not meaningful ). However, an Outlook is not necessarily a precursor of a rating change or future CreditWatch action
CreditWatch
The CreditWatch service highlights the potential direction of a short- or long-term rating, addressing identifiable events and short-term trends resulting in special surveillance, which in the case of sovereigns might include referenda or regulatory actions. Essentially, a CreditWatch listing means that a noteworthy event has occurred and additional information is necessary to evaluate the current rating. CreditWatch designations include positive (rating may be raised ); negative ( may be lowered ); and developing ( may be raised, lowered, or affirmed ).
As with a rating Outlook, a CreditWatch listing does not mean a rating change is inevitable, and conversely, rating changes may occur without the ratings having first appeared on CreditWatch.
Standard & Poor's Rating Process
A sovereign seeking a rating establishes a formal relationship with S&P by executing a written agreement governing the rating process. S&P sends information regarding its ratings criteria and requests a preliminary set of information from the sovereign.
The analysts review the various economic and financial data made available to them (at least five years worth), budget and economic projections, and any available longer-term projections, as well as any analyses on the country by organizations such as the IMF [International Monetary Fund] and the World Bank
Typically, a team of two analysts (possibly more if language presents an issue, or if private-sector ratings are being done simultaneously) visits a country for three to four days, meeting with representatives of the finance ministry, central bank, and other governmental agencies, as well as individuals and organizations outside the government who are well informed about economic and political trends in the country.
Upon completion of their meetings and analyses, the analysts prepare a report for submission to the rating committee, which discusses the report and votes on the eventual rating. This report generally includes all of the components of the eventual rating package in draft form.
Once the committee has arrived at a rating the sovereign is notified of the decision, and if the government accepts the rating, then S&P issues it to the public
The sovereign can appeal the rating once, typically providing new information or arguing that certain factors should be weighted differently, in which case the committee process is repeated for a final, unappealable decision
The rating committee considers both quantitative and qualitative factors in arriving at a rating decision. The process involves ranking the sovereign by a one-to-six scale (one being the best) with respect to each of 10 analytical categories, though there is no exact formula for combining the scores to determine ratings.
Specific analytical categories include political risk; income and economic structure; economic growth prospects; fiscal flexibility; general government debt burden; off-budget and contingent liabilities;
monetary flexibility; external liquidity; public-sector external debt burden; and private sector external debt burden.
The issue of political risk, a fundamentally qualitative issue, distinguishes sovereigns from most other types of issuers ; a sovereign has significant latitude simply to choose not to repay even when able, leaving creditors with limited legal redress.
S&P has identified certain key economic and political risks that weigh heavily on the analysis: (1) political institutions and trends, and particularly their impact on the effectiveness and transparency of the policy environment ; (2) economic structure and growth prospects; (3) government revenue flexibility and expenditure pressures, deficits and the debt burden, and contingent liabilities; (4) Foreign exchange position
Corporate debacles
A wave of corporate scandals emerged in the United States between late 2001 and the end of 2002. Hundreds of public corporations restated their financial statements, scores were sued by the SEC, and some executives were criminally prosecuted. The failures of Enron and WorldCom, revealed a complete breakdown in all systems of internal control and external monitoring. The collapse of two mammoth organizations within a few months of each other undermined the credibility of U.S. credit rating agencies.
Until four days before Enron declared bankruptcy on December 2, 2001, its debt was rated as investment grade by the major credit rating agencies. But its debt was actually in junk status.
Even more than Enron, WorldCom was a skyrocket that soared and then plunged. By 2001, WorldCom s situation had deteriorated, its stock prices had fallen and several underwriters, mainly the commercial banks, downgraded their internal credit ratings, but the rating agencies had rated WorldCom s debt as investment-grade even three months before the company filed for bankruptcy.
These scandals caused a lot of criticism and public outcry against the efficiency of the rating agencies.
Credit Rating Agencies in India
There are four Credit Rating agencies in India
CRISIL ICRA CARE and Fitch India
Regulatory Framework
Credit Rating agencies are regulated by SEBI. Registration with SEBI is mandatory for carrying out the rating Business.
Promoter
A Credit rating agency can be promoted by: Public Financial Institution Scheduled Bank Foreign Bank operating in India with RBI approval Foreign Credit Rating agency having at least five years experience in rating securities Any company having a continous net worth of minimum 100 crores for the previous five years.
Eligibility Criteria
Is set up and registered as a company Has specified rating activity as one of its main objects in its Memorandum of Association. Has a minimum Net worth of Rs 5 Crore. Has adequate Infrastructure Promoters have professional competence, financial soundness and a general reputation of fairness and integrity in Business transactions , to the satisfaction of SEBI. Has employed persons with adequate professional and other relevant experience, as per SEBI directions.
Grant of Certificate of Registration
SEBI will grant to eligible applicants a Certificate of Registration on the payment of a fee of Rs 5,00,000 subject to certain conditions.
CRISIL
The first rating agency Credit Rating Information Services of India Ltd. , CRISIL, was promoted jointly in 1987 jointly by the ICICI and the UTI.
ICRA Ltd
Information and Credit Rating Services (ICRA) has been promoted by IFCI Ltd as the main promoter and started operations in 1991. Other shareholders are UTI, Banks, LIC, GIC, Exim Bank, HDFC and ILFS. It provides Rating, Information and Advisory services ranging from strategic consulting to risk management and regulatory practice.
CARE Ltd.
Credit Analysis and Research Ltd or CARE is promoted by IDBI jointly with Financial Institutions, Public/Private Sector Banks and Private Finance Companies. It commenced its credit rating operations in October, 1993 and offers a wide range of products and Services in the field of Credit Information and Equity Research. It also provides advisory services in the areas of securitisation of transactions and structuring Financial Instruments.
Fitch Ratings India Ltd.
It is the latest entrant in the credit rating Business in the country as a joint venture between the international credit Rating agency Duff and Phelps and JM Financial and Alliance Group. In addition to debt instruments, it also rates companies and countries on request.
Rating Process
Issue of rating request letter by the issuer of the instrument and signing of the rating agreement. CRA assigns an analytical team consisting of two or more analysts one of whom would be the lead analyst and serve as the primary contact.
Meeting with Management Obtains and analyses information Analysts present their report to a rating committee After the committee has assigned the rating, the rating decision is communicated to the issuer, with reasons or rationale supporting the rating.
Dissemination to the Public: Once the issuer accepts the rating, the CRAs disseminate it, along with the rationale, to the print media.
Rating Review for a possible change:
The rated company is on the surveillance system of the CRA, and from time to time, the earlier rating is reviewed. Analysts review new information or data available on the company.
Rating change
Ts feel that there is a possibility of On preliminary analysis of the new data, if the analysts feel that there is a possibility of changing the rating, then the analysts request the issuer for a meeting with its management and proceed with a comprehensive rating analysis.
Credit Rating Watch
During the review monitoring or surveillance exercise, rating analysts might become aware of imminent events like mergers and so on, which effect the rating and warrants a rating change. In such a possibility, the issuer s rating is put on credit watch indicating the direction of a possible change and supporting reasons for review.
Rating Methodology
Business Analysis in terms of Industry Risk, Market position, operating efficiency and legal position. Financial analysis on the basis of consideration of accounting quality, earnings protection and adequacy of cash flows. Management Evaluation. Regulatory Environment.
Credit Rating of Indian States
Rating of the states by the CRISIL represents a landmark in the diversification of the rating Business in the country. It has already rated several states. While assessing a state, CRISIL considers two basic factors: The Economic Risk and The Political Risk
Economic Risk
Economic structure of the state and its finances Macroeconomic performance Infrastructure Sector studies Whether revenue and expenditure patterns are sustainable. Deficit Management
Degree of dependence on Central support Tax policy of the state Performance of Public sector undertakings and their effect on the state s finances.
Political Risk
Relations between the state and the Centre and its impact on transfer of resources as well as centre s influence on political stability in the state. Various political parties in the state, their economic policies and their effect on the state s policies.
Quality of the current leadership and administration Ability of the Government to take decisions that are politically difficult.
Questions for Revision
What is Credit Rating ? Describe how it started and evolved ? How do rating agencies generate their revenue ? What is meant by
± Investment grade securities ± Speculative grade securities
Questions for Revision
Write a short Note on
± Rating Process ± Rating outlook ± Credit watch
Describe briefly the regulatory framework for credit rating agencies in India ? Describe some of the important eligibility criteria for a rating agency ?
Questions for Revision
What is the methodology followed by Rating agencies in India for Industry ? What are the basic factors considered while assessing a state ? Write short Notes on
± ± ± ± CRISIL ICRA CARE Fitch Ratings India
Questions for Revision
What is the difference between obligor default rating (ODR) and loss given default rating (LGDR)? Write a short Note on Internal Risk Rating?
The End
Commercial credit risk is the largest and most elementary risk faced by many banks, and it is a major risk for many other kinds of financial institutions and corporations as well.
many uncertain elements are involved in determining both how likely it is that an event of default will happen and how costly default will turn out to be if it does occur.
Some of the newest approaches employ equity market data to track the likelihood of default by public companies, while other approaches have been developed to assess credit risk at the portfolio level using mathematical and statistical modeling
Traditional approach
Creditrisk assessments within an overall framework known as a credit rating system
To make a credit assessment
analysts must take into consideration many complex attributes of a firm financial and managerial, quantitative and qualitative.
They must ascertain the financial health of the firm, determine whether earnings and cash flows are sufficient to cover any debt obligations, analyze the quality of the firm s assets, and examine its liquidity position.
In addition, analysts must take into account the nature of the industry to which the potential client belongs, the status of their new client within that industry, and the potential effect of macroeconomic events on the firm (including any country risks, such as a political upheaval or currency crisis).
A credit rating system is simply a way of organizing and systematizing all these procedures so that credit analysts across a firm arrive at ratings that are rational, coherent, and comparable.
We ll look first at how credit rating agencies (key players in the development of modern ratings) arrive at their public credit ratings of large corporations.
Then we ll take a look at how banks arrive at their own private internal ratings of firms, large and small, that lack a public credit rating.
Internal risk rating systems are one of the banking industry s oldest and most widely used credit-risk measurement tools, but practices are changing fast as a result of both regulatory and competitive pressures. Internal rating systems allow the analysis of thousands of borrowers within a consistent framework and permit comparisons across the entire loan portfolio.
PURPOSE OF INTERNAL RISK RATING SYSTEMS (IRRS)
Setting limits and acceptance or rejection of new transactions. The strength of the rating awarded to an entity or transaction is likely to play a key role in the decision to accept or reject a particular transaction. Credit-risk limits are often set in terms of rating categories. Also, concentration limits by name, industry, and country are established and revised annually by the senior risk committee of the bank.
Monitoring of credit quality
Ratings should be reviewed periodically at least once a year or if a specific event justifies the revision of the credit assessment of a borrower. Credit migration is a critical component in monitoring the credit quality of the loan portfolios of banks.
Attribution of economic capital
Best-practice institutions will have a risk adjusted return on capital (RAROC) system in place to assess the contribution to shareholder value of the firm s activities and portfolios. Internal ratings are key input in the economic capital allocation process to credit portfolios.
Risk adjusted return on capital (RAROC)
RAROC is defined as the ratio between the Expected Return and Economic Capital. The expected return is the return minus expected losses. Economic Capital is the money which is needed to secure the survival in a worst case scenario. This is a function of the market, credit and operational risks and is often calculated by Var.
Adequacy of loan loss reserves
Both regulators and management use the distribution of portfolio quality, as measured by internal ratings, to judge the adequacy of the financial accountingbased reserve for loan losses and the provision for losses in the current accounting period.
Adequacy of capital
Again, both regulators and management, and also rating agencies, use the portfolio risk profile, as measured by internal ratings, to judge the fundamental creditworthiness of the institution as a whole.
Pricing and trading of loans
Internal ratings are key inputs for credit portfolio models from which the risk contribution of each facility in a credit portfolio can be derived. In turn, these risk contributions help determine the minimum spread that an institution should charge on a credit facility in order to factor in the cost of credit risk. Failing to take account of the relative cost of extending credit destroys shareholder value
RATING AGENCIES
The External Agency Rating Process
The issuance of bonds by corporations is a twentieth-century phenomenon. Soon after bonds began to be issued, companies such as Moody s (1909), Standard & Poor s (1916), and other agencies started to offer independent assessments of how likely it was that particular bonds would repay investors in the way they were intended to do.
Over the last 30 years, the introduction of new financial products has led to the development of new methodologies and criteria for credit rating: Standard & Poor s (S&P) was the first rating company to rate mortgage-backed bonds (1975), mutual funds (1983), and asset-backed securities (1985).
A credit rating is not, in general, an investment recommendation for a given security. When rating a security, a rating agency focuses more on the potential downside loss than on the potential upside gain.
In the words of S&P
A credit rating is S&P s opinion of the general creditworthiness of an obligor, or the creditworthiness of an obligor with respect to a particular debt security or other financial obligation, based on relevant risk factors.
In Moody s words
a rating is, an opinion on the future ability and legal obligation of an issuer to make timely payments of principal and interest on a specific fixed income security.
S&P and Moody s have access to a corporation s internal information, and since they are considered to have expertise in credit rating and are generally regarded as unbiased evaluators, their ratings are widely accepted by market participants and regulatory agencies.
Financial institutions, when required by their regulators to hold investment-grade bonds, use the ratings of credit agencies such as S&P and Moody s to determine which bonds are of investment grade.
There are two main classes of ratings
With issuer credit ratings, the rating is an opinion on the obligor s overall capacity to meet its financial obligations. In the issuer credit rating category are counterparty ratings, corporate credit ratings, and sovereign credit ratings.
Issue-specific credit ratings
Another class of rating is issue-specific credit ratings. In this case, the rating agency makes a distinction, in its rating system and symbols, between long-term and short-term credits. The short-term ratings apply to commercial paper (CP), certificates of deposit (CD), etc. The rating is of a specific issue, and not the issuer.
In rating a specific issue, the attributes of the issuer, as well as the specific terms of the issue, the quality of the collateral, and the creditworthiness of the guarantors, are taken into account.
The rating process includes quantitative, qualitative, and legal analyses. The quantitative analysis is mainly financial analysis and is based on the firm s financial reports. The qualitative analysis is concerned with the quality of management; it includes a thorough review of the firm s competitiveness within its industry as well as the expected growth of the industry and its vulnerability to business cycles, technological changes, regulatory changes, and labor relations.
Process of rating an industrial company
The analyst works through sovereign and macroeconomic issues, industry outlook, and regulatory trends, to specific attributes (including quality of management, operating position, and financial position), and eventually to the issue-specific structure of the financial instrument.
The assessment of management, which is subjective in nature, investigates how likely it is that management will achieve operational success and takes the temperature of its tolerance for risk. The rating process includes meetings with the management of the issuer to review operating And financial plans, policies, and strategies.
All the information is reviewed and discussed by a rating committee with appropriate expertise in the relevant industry, which then votes on the recommendation. The issuer can appeal the rating before it is made public by supplying new information. The rating decision is usually issued four to six weeks after the agency is asked to rate a debt issue.
Moody s Rating Analysis of an Industrial Company
Issue Structure Company Structure Operating/Financial Position Management Quality Industry/Regulatory Trends Sovereign/Macroeconomic Analysis
Usually the ratings are reviewed once a year based on new financial reports, new business information, and review meetings with management. A credit watch or rating review notice is issued if there is reason to believe that the review may lead to a credit rating change. A change of rating has to be approved by the rating committee.
Credit Ratings by S&P and Moody s
Standard & Poor s (S&P) is one of the world s major rating agencies, operating in more than 50 countries. Moody s operates mainly in the United States but has many branches internationally
Issues rated in the four highest categories (i.e., AAA, AA, A, and BBB for S&P and Aaa, Aa, A, and Baa for Moody s) are generally considered to be of investment grade.
Some financial institutions, for special or approved investment programs, are required to invest only in bonds or debt instruments that are of investment grade. Obligations rated BB, B, CCC, CC, and C by S&P (Ba, B, Caa, Ca, and C by Moody s) are regarded as having significant speculative characteristics. BB (Ba in Moody s) is the least risky, and C is the most risky.
S&P uses plus or minus signs to modify its AA to CCC ratings in order to indicate the relative standing of a credit within the major rating categories. Similarly, Moody s applies numerical modifiers 1, 2, and 3 in each generic rating classification from Aa through Caa. The modifier 1, for example, indicates that the obligation ranks at the higher end of its generic rating category; thus B1 in Moody s rating system is a ranking equivalent to B! in S&P s rating system.
How accurate are agency ratings
based on data from the period 1981 to 2004 the lower the rating, the higher the cumulative default rates. The Aaa and Aa bonds experienced very low default rates; after 10 years, less than 1 percent of the issues had defaulted. Approximately 35 percent of the B-rated issues, however, had defaulted after 10 years.
Historical data seem to offer a general validation of agency ratings. But they are useful for another reason: they allows risk analysts to attach an objective likelihood of default to any company that has been rated by an agency or that has been rated by banks in a manner thought to be equivalent to an agency rating.
While the major rating agencies use similar methods and approaches to rate debt, they sometimes come up with different ratings for the same debt investment. Academic studies of the credit rating industry have shown that only just over half of the firms rated AA or Aa and AAA or Aaa in a large sample were rated the same by the two top agencies. The same study found that smaller agencies tend to rate debt issues higher than or the same as S&P and Moody s; only rarely do they award a lower rating
DEBT RATING AND MIGRATION
Bankruptcy, whether defined as a legal or an economic event, usually marks the end of a corporation in its current form. It is a discrete event, yet it is also the final point in a continuous process the moment when it is finally recognized that a firm cannot meet its financial obligations.
credit agencies do not focus simply on default. At discrete points in time, they revise their credit ratings of corporate bonds. This evolution of credit quality is very important for an investor holding a portfolio of corporate bonds.
INTERNAL RISK RATING
banks are in the business of lending money to a very wide spectrum of companies, not just those that issue public debt (and that therefore find it useful to invest in gaining a credit rating). Many smaller and private companies are not even listed on a public stock exchange, so that much of the financial data that can be gathered about them are of unproven quality.
Typically, a bank IRRS assigns two kinds of ratings. First, it assigns an obligor default rating (ODR) to each borrower (or group of borrowers) that identifies the borrower s probability of default. Second, it assigns a loss given default rating (LGDR) to each available facility, independently of the ODR, that identifies the risk of loss from that facility in the event of default on the obligation.
To understand the fundamental difference between these two kinds of rating, let s consider the key concept of expected loss. The expected loss of a particular transaction or portfolio is the product of the amount of credit exposure at default (say, $100) multiplied by the probability of default (say, 2 percent) for an obligor (or borrower) and the loss rate given default (say, 50 percent) in any specific credit facility. In this example, the expected loss is $100 * 0.02 * 0.50 = $1.
The ODR represents simply the probability of default by a borrower in repaying its obligation in the normal course of business. The LGDR, on the other hand, assesses the conditional severity of the loss, should default occur. The severity of the loss on any facility is considerably influenced by whether the bank has put in place risk mitigation tools such as guarantees, collateral, and so on.
As well as identifying the risks associated with a borrower and a credit facility, an IRRS also provides a key input for the capital charges used in various pricing models and for riskadjusted return on capital (RAROC) systems
Steps in the IRRS
FINANCIAL ASSESSMENT (STEP 1)
Introduction
This step formalizes the thinking process of a good credit analyst (or good equity analyst), whose goal is to ascertain the financial health of an institution. The credit analyst might begin by studying the institution s financial reports to determine whether the earnings and cash flows are sufficient to cover the debt repayments. The credit analyst will study the degree to which the trends associated with these financials are stable and positive.
The credit analyst will also want to analyze the company s assets to determine whether they are of high quality, and to make sure that the obligor has substantial cash reserves (e.g., substantial working capital5). The analyst will also want to examine the firm s leverage. Similarly, the credit analyst will want to analyze the extent to which the firm has access to the capital markets, and whether it is able to borrow the money that it will need to carry out its business plans.
The rating should reflect the company s financial position and performance and its ability to withstand any financial setbacks.
Procedure
The three main assessment areas, are (1) earnings and cash flow; (2) asset values, liquidity, and leverage; and (3) financial size, flexibility, and debt capacity.
A measure for earnings and cash flow would take into account interest coverage expressed in terms of key accounting ratios for example, the ratio of earnings before interest and taxes (EBIT) to interest expense and the ratio of earnings before interest, taxes, depreciation, and amortization (EBITDA) to interest expense
The analysis would emphasize the current year s performance, with some recognition of the previous few years as appropriate. When assessing companies in cyclical industries, the analyst should adjust the financial results and key ratios so that the cyclical effect is incorporated.
A measure for leverage might be ratios of debt to net worth such as total liabilities to equity or (total liabilities minus debt) to equity.
When assessing the financial size, flexibility, and debt capacity category, the size of the market capitalization will be an important factor.
The analyst would calculate a risk rating for each of the three assessment areas and then arrive at an assessment of the best overall risk rating. This is the initial obligor rating.
Industry Benchmarks
The analysis of a firm s competitive position and operating environment helps in assessing the firm s general business risk profile. This profile can be used to calibrate quantitative information drawn from the financial ratios for the firm,
A company with an excellent business in a growing or stable sector can assume more debt than a company with less glowing prospects
Management and Other Qualitative Factors (Step 2)
This second step considers the impact on an obligor rating of a variety of qualitative factors, such as discovering unfavorable aspects of a borrower s management. Step 2 analysis may bring about a downgrade if standards are not acceptable.
A typical Step 2 approach would require such activities as examining day-to-day account operations, assessing management, performing an environmental assessment, and examining contingent liabilities
For example, in the case of day-to-day account operations, is the firm s financial reporting on a timely basis and of good quality? Does the firm satisfactorily explain any significant variations from projections? Are credit limits and terms respected? Does the company honor its obligations to creditors?
In the case of a management assessment, the analyst might check that management skills are sufficient for the size and scope of the business. Does management have a record of success and appropriate industry experience? Does management have adequate depth (for example, are succession plans in place)? Is there an informed approach to identifying, accepting, and managing risks?
Does management address problems promptly, exhibiting the will to take hard decisions as necessary, with an appropriate balance of short- to long-term concerns? Is management remuneration prudent and appropriate to the size, financial strength, and progress of the company?
Industry Ratings Summary (Step 3a)
The importance of interaction between an industry rating and the relative position of the borrower within its industry. Experience has shown that poorer-tier performers in weak, vulnerable industries are major contributors to credit losses.
using an industry assessment (IA) ratings scheme for each industry. To calculate the industry assessment, the analyst first assigns a score of 1 (minimal risk) to 5 (very high risk) for each of a set of, say, eight criteria established by the bank. For example, each industry might be described in terms of its competitiveness, trade environment, regulatory framework, restructuring, technological change, financial performance, long-term trends affecting demand, and vulnerability to macroeconomic environment.
Tier Assessment (Step 3b)
The criteria and process used to assess industry risk can often be reapplied to determine a company s relative position (say, on a scale of tiers 1 to 4) within an industry. A business should be ranked against its appropriate competition. That is, if the company supplies a product or service that is subject to global competition, then it should be ranked on a global basis. If the company s competitors are by nature local or regional, as is the casefor many retail businesses, then it should be ranked on that basis
In a four-tier system, tier 1 players are major players with a dominant share of the relevant market (local, regional, domestic, international, or niche). They have a diversified and growing customer base and have low production costs that are based on sustainable factors (such as a diversified supplier base, economies of scale, location and resource availability, continuous upgrading of technology, and so on). Such companies respond quickly and effectively to changes in the regulatory framework, trading environment, technology, demand patterns, and macroeconomic environment.
Tier 2 players are important or above-average industry players with a meaningful share of the relevant market (local, regional, domestic, international, or niche). Tier 3 players are average (or modestly below average) industry players, with a moderate share of the relevant market (local, regional, domestic, international, or niche). Tier 4 players are weak industry players with a declining customer base. They have a high cost of production as a result of factors such as low leverage with suppliers, obsolete technologies, and so on.
Industry/Tier Position (Step 3c)
This final part of the third step (Step 3c) combines the assessments of the health of the industry (i.e., the industry rating) and the position of a business within its industry (i.e., the tier rating). While the tier rating can be lowered if the industry/tier assessment is weak, it will not be raised if this position is strong. The process reveals the vulnerability of a company, particularly during recessions. Low-quartile competitors within an industry class almost always have higher risk (modified by the relative health of the industry).
Financial Statement Quality (Step 4)
This fourth step recognizes the importance of the quality of the financial information provided to the analyst. This includes consideration of the size and capabilities of the accounting firm compared to the size and complexities of the borrower and its financial statements. Again, the rating should not be raised even if the result is good; the point of this step is to define the highest possible rating that can be obtained.
Country Risk (Step 5)
This fifth step adjusts for the effect of any country risk. Country risk is the risk that a counterparty or obligor will not be able to pay its obligations because of crossborder restrictions on the convertibility or availability of a given currency. It is also an assessment of the political and economic risk of a country. Country risk exists when more than a prescribed percentage (say 25 percent) of the obligor s (gross) cash flow (or assets) is located outside of the local market.
Country risk may be mitigated by hard currency cash flow received or earned by the counterparty. Hard currency cash flow refers to revenue in a major (i.e., readily exchanged) international currency (primarily U.S. and Canadian dollars, sterling, euro, and Japanese yen). Again, Step 5 limits the best possible rating. For example, if the client s operation has a country rating in the fair category, then the best possible obligor rating might be limited to 5.
Comparison to External Ratings (Step 6)
When the obligor is rated by an external rating agency or when it is included in the database of an external service providing default probability estimates, such as KMV, the preliminary ODR produced in Step 5 is compared to these external ratings. The intent is not to align the internal rating with that of an external agency but to ensure that all appropriate risk issues have been factored into the final ODR.
When the ODR differs substantially from the external rating, then the rater should review the assessment on which the rating process is based (Steps 1 to 5). If the comparison suggests that important risk factors were overlooked or underestimated in the preliminary analysis, then these factors should be incorporated in the final ODR by revising Steps 1 through 5.
This step can be viewed as a sanity check to validate the internally derived ODR and ensure the completeness of the analysis followed in Steps 1 through 5.
Loan Structure (Step 7)
The risk rating process (Steps 1 through 6) assumes that most credits have an appropriate loan structure in place. If so, Step 7 has no impact on the ODR. However, if the loan structure is not sufficiently strong and is viewedas having a negative impact on the risk of default of the obligor, then a downgrade is required. As a general rule, the weaker the preliminary ODR concluded in Step 6, the more stringent the loan structure should be to be regarded as appropriate.
The components of the loan structure that may affect default risk are the financial covenants, the term of the debt, its amortization scheme, and change-of-control restrictions. For example, in the case of high-risk companies, financial ratio requirements should be progressive and should fit tightly with the company s own forecasts. In addition, significant amortization of debt over the tenure of the facilities should be imposed, and nonmerger restrictions should be put in place.
LOSS GIVEN DEFAULT RATING (LGDR)
Step 8 assigns a loss given default rating to each facility. This rating is determined independently of default probabilities. The probability of default and the loss experienced in the event of default are separate risk issues and therefore should be looked at independently. Typically, each LGDR is mapped to an LGD factor, i.e., a number between 0 and 100 percent, with 0 percent corresponding to the case of total recovery and 100 percent to the situation where the creditor loses all the amount due. The LGD should be calculated net of the recovery cost.
Different evaluation methods are used depending on whether the credit is unsecured or is secured by third-party support or collateral. The presence of security should mitigate the severity of the loss given default for any facility. The quality and depth of security varies widely and will determine the extent of the benefit in reducing any loss.
When the credit is secured by a guarantor, the analyst must be convinced that the third party/owner is committed to ongoing support of the obligor. When a facility is protected by collateral, the collateral category should reflect only the security held for the facility that is being rated.
Collateral can have a major effect on the final LGDR, but the value of collateral is often far from straightforward. The value of securities used as collateral is often a function of movements in market rates. In the most worrying situation, collateral values tend to move down as the risk ofobligor default rises. For example, real estate used as collateral for a loan to a property developer has a strong tendency to lose its value during a property downturn the moment in the sector cycle when a property developer is most likely to default.
the new Basel Capital Accord (Basel II) puts a special emphasis on the internal rating based approach for creditrisk attribution. In the future, many banks will be able to use their internal ratings to calculate the amount of regulatory risk capital they must put aside for key credit risks. But to do so, banks will have to prove that their internal rating system meets certain standards.
The history of the ratings industry began in the USA in the late 19th century with the building of the country s railway system. The debt instruments issued by the various railways were a tempting target for risk classification for investors. The precursors of bond rating agencies were the mercantile credit agencies, which rated merchants' ability to repay their financial obligations.
In 1841, Louis Tappan established the first mercantile credit agency in New York. Robert Dun, subsequently,acquired the agency and published its first ratings guide in 1859. A similar mercantile rating agency was formed in 1849 by John Bradstreet, who published a ratings book in 1857. In 1933, the two agencies were consolidated into Dun and Bradstreet, which later acquired Moody's Investors Service (in 1962).
Gradually, the mercantile rating agencies began providing ratings on other financial instruments and securities like bonds, bank deposits and commercial papers. Moody s began by rating railroad bonds (1909), and a year later, extended its ratings activity to utility and industrial bonds.
The Fitch Publishing Company was established in 1924. Standard & Poor s (S&P) was formed with the merger of Poor's Publishing Company and Standard Statistics Company in 1941.
The major agencies were either independent or owned by nonfinancial companies. Moody's, a subsidiary of Dun and Bradstreet, dominated the market for commercial credit ratings. Standard and Poor's was a subsidiary of McGraw-Hill, a major publishing company with a strong business information focus. Fitch, initially a publishing company, was bought by an independent investor group in 1989.
The three primary rating agencies are as follows: 1. Moody s Investor Service 2. Standard & Poor s 3. Fitch
Moody s and S&P are generally considered the most influential because they have the widest geographical coverage.
The agencies operate without government mandate, and have remained independent from the investment community. It is because of their independence and reputation for being objective that their opinions are accepted as credible by the investment community.
Rating agencies generate their revenues from two primary sources:
1. Fees from issuers that solicit ratings for their securities, which consist of both per-issue fees and annual fees. The amount of the fee depends on the type and size of security being rated and on the total number of securities of the issuer already rated by the agency. For bonds and preferred stock, per-issue fees for both Moody s and S&P have a minimum of $25,000 $30,000 and a maximum of 225,000 $250,000. Annual fees range from $12,500 to $15,000.
2. The sale of research, software, and other proprietary information.
At first glance, it may seem unusual that rating agencies are able to charge issuers to have their credit quality scrutinized. In particular, why should a firm pay to get a low or disappointing rating? The alternative, however, is to attempt to issue the security with no rating, which is tantamount to signaling the very poorest of investment quality.
Over the years, the rating agencies have established a reputation as providing reliable assessments of risk in the capital markets so much so, that a low rating is better than no rating in terms of the price paid for a new issue and the level of demand for the issue. On the flip side, receiving a high rating works strongly in an issuer s favor by signaling to the market that the issue deserves favorable pricing.
Such signaling would not be credible in the capital markets without the services of a highly reputable third party whose livelihood depends directly on its reputation for accuracy and independence.
Rating Categories
Ratings are constructed to represent the risk of default; that is, a high (low) rating implies a low (high) probability of default. Default refers to any event that results in the issuer s breaching its financial contract.
Large companies with strong and stable cash flows are likely to be rated higher than small companies with more volatile cash flows.
Investment grade refers to the safest levels of financial securities. Investment-grade securities have historically exhibited relatively low rates of default.
Speculative grade, or noninvestment grade, refers to the riskier securities. Debt rated BB (Ba for Moody s) or below is noninvestment grade, and is sometimes referred to as high yield or junk. Default rates among these classes of securities are comparatively high.
Within the major rating categories (AA, A, etc.), credit ratings are often modified to show relative standing within a category. Moody s uses numbers 1, 2, and 3, while S&P and Fitch use plus (+) and minus ( ) signs.
For example, the three tiers of the triple-B category are as follows:
Moody's Baa1 Baa2 Baa3 S&P BBB+ BBB BBBFitch BBB+ BBB BBBIntermediate
Notching
Rating agencies recognize the relative risk of securities issued by the same firm by notching the issues relative to each other. Debt obligations have varying degrees of risk, depending on their priority in a company s capital structure.
For example, senior debt has priority over subordinated debt in bankruptcy and will therefore receive a higher rating. Similarly, secured debt will receive a higher rating over unsecured debt because of its senior claim.
A specific example is CSX Corporation, a transportation company headquartered in Richmond, Virginia, which received a Moody s rating for its equipment trust certificates (secured debt) of A1, a rating of Baa2 for its senior unsecured debt, and a Baa3 rating for its subordinated debt. Its subordinated debt is said to be rated one notch below its senior debt.
Rating Outlooks
Rating agencies recognize the possibility that future performance will deviate from initial expectations. Rating outlooks address this matter by focusing on scenarios that could result in a rating change. For example, a security could be placed on Moody s Review or S&P s CreditWatch because of a merger announcement if it has the potential to affect, either adversely or positively, the ability of an issuer to meet its obligations. Rating reviews are normally completed within 60 to 90 days or as soon as the situation has been resolved.
The Rating Process
The first step in the process is for the rating agencies to meet with company management. The purpose of this meeting is to discuss the proposed offering, the company s operating and financial performance and outlook, and a host of other factors that might affect the rating. The company s chief financial officer is the main participant in these discussions, with the chief executive officer participating in any strategy discussions.
Following this meeting, the rating agencies assign a team of individuals to analyze the transaction. This team includes the relevant industry analyst and a product analyst if the security to be rated is specialized. The team reviews the offering documents, financial statements, and management s presentation, which includes the terms of the proposed offering, use of proceeds, historical and pro forma financial analysis, competitive analysis, capital-expenditure plans, etc. The rating agency s analysis, projections, and opinions may vary from those of the company s management or their investment bankers.
When the rating team has finished its analysis, a recommendation is made to an internal rating committee that votes on the proposed rating. Once the rating is determined, the company is notified and the rationale behind the rating is explained. A rating is often assigned within two weeks, depending on the nature of the proposed transaction, the current demand for ratings by other issuers, and the urgency of the company s request.
Both Moody s and S&P allow the company to respond to the rating before it is released to the media, which gives the company the opportunity to appeal and present additional data supporting a higher rating. After the final rating is assigned, the industry analyst tracks the company s performance and adjusts the rating, as appropriate, over time.
Provided there are no specific concerns or additional issuances of securities, the rating agency typically conducts formal quarterly reviews and meets with management at least once annually to stay current with the company s development.
Rating Methodology
Assigning a rating involves a comprehensive review and analysis of a number of important categories of information with respect to the issue or issuer.
Because ratings are relative measures of default risk, it is not surprising that companies with stronger financial measures have higher ratings, on average.
The Role of Ratings in the Capital Markets
Ratings provide benefits to both issuers and investors. Issuing companies with an investmentgrade rating enjoy wide and relatively inexpensive access to capital. Many investors, such as insurance companies, can invest only a limited percentage of funds in either speculativegrade or unrated securities. Thus, companies that have investment-grade ratings expand their universe of potential investors considerably.
For investors
For investors, ratings primarily reduce uncertainty. Less uncertainty encourages market growth and greater efficiency and liquidity. Ratings also widen investors horizons by providing expert analysis of issues or issuers that can be difficult for even the most sophisticated investors to examine. Finally, ratings provide benchmark investment limits, so that a pension fund, for example, can manage its risk by stipulating a limit on the percentage of its assets that can be invested in securities below a certain rating.
Standard & Poor's Sovereign Credit Ratings: Scales and Process
S&P s long-term credit-rating scale establishes a lettergrade hierarchy.
Ratings include AAA ( extremely strong repayment capacity); AA ( very strong ); A ( strong ); BBB ( adequate ); BB ( less vulnerable ); B ( more vulnerable ); CCC ( currently vulnerable );
CC ( currently highly vulnerable ); R ( under regulatory supervision owing to its financial condition ); SD ( selective default ); D ( default ); and NR ( not rated ).
Ratings of BBB and above are considered investment grade, while ratings of BB and below are noninvestment grade, or speculative grade.
Short-term credit ratings
Short-term credit ratings also consist of letter grades, but according to a simpler scale including A-1 ( strong repayment capacity); A-2 ( satisfactory ); A-3 ( adequate ); B ( more vulnerable ); C ( currently highly vulnerable );
R ( under regulatory supervision ); SD ( selective default ); D ( default ); and NR ( not rated ).
Rating Outlook
A rating Outlook assesses the potential direction of a long-term credit rating over the intermediate to longer term, addressing any changes in the economic and/or fundamental business conditions. Outlook categories include Positive (rating may be raised ); Negative ( may be lowered ); Stable ( not likely to change ); Developing ( may be raised or lowered ); and NM ( not meaningful ). However, an Outlook is not necessarily a precursor of a rating change or future CreditWatch action
CreditWatch
The CreditWatch service highlights the potential direction of a short- or long-term rating, addressing identifiable events and short-term trends resulting in special surveillance, which in the case of sovereigns might include referenda or regulatory actions. Essentially, a CreditWatch listing means that a noteworthy event has occurred and additional information is necessary to evaluate the current rating. CreditWatch designations include positive (rating may be raised ); negative ( may be lowered ); and developing ( may be raised, lowered, or affirmed ).
As with a rating Outlook, a CreditWatch listing does not mean a rating change is inevitable, and conversely, rating changes may occur without the ratings having first appeared on CreditWatch.
Standard & Poor's Rating Process
A sovereign seeking a rating establishes a formal relationship with S&P by executing a written agreement governing the rating process. S&P sends information regarding its ratings criteria and requests a preliminary set of information from the sovereign.
The analysts review the various economic and financial data made available to them (at least five years worth), budget and economic projections, and any available longer-term projections, as well as any analyses on the country by organizations such as the IMF [International Monetary Fund] and the World Bank
Typically, a team of two analysts (possibly more if language presents an issue, or if private-sector ratings are being done simultaneously) visits a country for three to four days, meeting with representatives of the finance ministry, central bank, and other governmental agencies, as well as individuals and organizations outside the government who are well informed about economic and political trends in the country.
Upon completion of their meetings and analyses, the analysts prepare a report for submission to the rating committee, which discusses the report and votes on the eventual rating. This report generally includes all of the components of the eventual rating package in draft form.
Once the committee has arrived at a rating the sovereign is notified of the decision, and if the government accepts the rating, then S&P issues it to the public
The sovereign can appeal the rating once, typically providing new information or arguing that certain factors should be weighted differently, in which case the committee process is repeated for a final, unappealable decision
The rating committee considers both quantitative and qualitative factors in arriving at a rating decision. The process involves ranking the sovereign by a one-to-six scale (one being the best) with respect to each of 10 analytical categories, though there is no exact formula for combining the scores to determine ratings.
Specific analytical categories include political risk; income and economic structure; economic growth prospects; fiscal flexibility; general government debt burden; off-budget and contingent liabilities;
monetary flexibility; external liquidity; public-sector external debt burden; and private sector external debt burden.
The issue of political risk, a fundamentally qualitative issue, distinguishes sovereigns from most other types of issuers ; a sovereign has significant latitude simply to choose not to repay even when able, leaving creditors with limited legal redress.
S&P has identified certain key economic and political risks that weigh heavily on the analysis: (1) political institutions and trends, and particularly their impact on the effectiveness and transparency of the policy environment ; (2) economic structure and growth prospects; (3) government revenue flexibility and expenditure pressures, deficits and the debt burden, and contingent liabilities; (4) Foreign exchange position
Corporate debacles
A wave of corporate scandals emerged in the United States between late 2001 and the end of 2002. Hundreds of public corporations restated their financial statements, scores were sued by the SEC, and some executives were criminally prosecuted. The failures of Enron and WorldCom, revealed a complete breakdown in all systems of internal control and external monitoring. The collapse of two mammoth organizations within a few months of each other undermined the credibility of U.S. credit rating agencies.
Until four days before Enron declared bankruptcy on December 2, 2001, its debt was rated as investment grade by the major credit rating agencies. But its debt was actually in junk status.
Even more than Enron, WorldCom was a skyrocket that soared and then plunged. By 2001, WorldCom s situation had deteriorated, its stock prices had fallen and several underwriters, mainly the commercial banks, downgraded their internal credit ratings, but the rating agencies had rated WorldCom s debt as investment-grade even three months before the company filed for bankruptcy.
These scandals caused a lot of criticism and public outcry against the efficiency of the rating agencies.
Credit Rating Agencies in India
There are four Credit Rating agencies in India
CRISIL ICRA CARE and Fitch India
Regulatory Framework
Credit Rating agencies are regulated by SEBI. Registration with SEBI is mandatory for carrying out the rating Business.
Promoter
A Credit rating agency can be promoted by: Public Financial Institution Scheduled Bank Foreign Bank operating in India with RBI approval Foreign Credit Rating agency having at least five years experience in rating securities Any company having a continous net worth of minimum 100 crores for the previous five years.
Eligibility Criteria
Is set up and registered as a company Has specified rating activity as one of its main objects in its Memorandum of Association. Has a minimum Net worth of Rs 5 Crore. Has adequate Infrastructure Promoters have professional competence, financial soundness and a general reputation of fairness and integrity in Business transactions , to the satisfaction of SEBI. Has employed persons with adequate professional and other relevant experience, as per SEBI directions.
Grant of Certificate of Registration
SEBI will grant to eligible applicants a Certificate of Registration on the payment of a fee of Rs 5,00,000 subject to certain conditions.
CRISIL
The first rating agency Credit Rating Information Services of India Ltd. , CRISIL, was promoted jointly in 1987 jointly by the ICICI and the UTI.
ICRA Ltd
Information and Credit Rating Services (ICRA) has been promoted by IFCI Ltd as the main promoter and started operations in 1991. Other shareholders are UTI, Banks, LIC, GIC, Exim Bank, HDFC and ILFS. It provides Rating, Information and Advisory services ranging from strategic consulting to risk management and regulatory practice.
CARE Ltd.
Credit Analysis and Research Ltd or CARE is promoted by IDBI jointly with Financial Institutions, Public/Private Sector Banks and Private Finance Companies. It commenced its credit rating operations in October, 1993 and offers a wide range of products and Services in the field of Credit Information and Equity Research. It also provides advisory services in the areas of securitisation of transactions and structuring Financial Instruments.
Fitch Ratings India Ltd.
It is the latest entrant in the credit rating Business in the country as a joint venture between the international credit Rating agency Duff and Phelps and JM Financial and Alliance Group. In addition to debt instruments, it also rates companies and countries on request.
Rating Process
Issue of rating request letter by the issuer of the instrument and signing of the rating agreement. CRA assigns an analytical team consisting of two or more analysts one of whom would be the lead analyst and serve as the primary contact.
Meeting with Management Obtains and analyses information Analysts present their report to a rating committee After the committee has assigned the rating, the rating decision is communicated to the issuer, with reasons or rationale supporting the rating.
Dissemination to the Public: Once the issuer accepts the rating, the CRAs disseminate it, along with the rationale, to the print media.
Rating Review for a possible change:
The rated company is on the surveillance system of the CRA, and from time to time, the earlier rating is reviewed. Analysts review new information or data available on the company.
Rating change
Ts feel that there is a possibility of On preliminary analysis of the new data, if the analysts feel that there is a possibility of changing the rating, then the analysts request the issuer for a meeting with its management and proceed with a comprehensive rating analysis.
Credit Rating Watch
During the review monitoring or surveillance exercise, rating analysts might become aware of imminent events like mergers and so on, which effect the rating and warrants a rating change. In such a possibility, the issuer s rating is put on credit watch indicating the direction of a possible change and supporting reasons for review.
Rating Methodology
Business Analysis in terms of Industry Risk, Market position, operating efficiency and legal position. Financial analysis on the basis of consideration of accounting quality, earnings protection and adequacy of cash flows. Management Evaluation. Regulatory Environment.
Credit Rating of Indian States
Rating of the states by the CRISIL represents a landmark in the diversification of the rating Business in the country. It has already rated several states. While assessing a state, CRISIL considers two basic factors: The Economic Risk and The Political Risk
Economic Risk
Economic structure of the state and its finances Macroeconomic performance Infrastructure Sector studies Whether revenue and expenditure patterns are sustainable. Deficit Management
Degree of dependence on Central support Tax policy of the state Performance of Public sector undertakings and their effect on the state s finances.
Political Risk
Relations between the state and the Centre and its impact on transfer of resources as well as centre s influence on political stability in the state. Various political parties in the state, their economic policies and their effect on the state s policies.
Quality of the current leadership and administration Ability of the Government to take decisions that are politically difficult.
Questions for Revision
What is Credit Rating ? Describe how it started and evolved ? How do rating agencies generate their revenue ? What is meant by
± Investment grade securities ± Speculative grade securities
Questions for Revision
Write a short Note on
± Rating Process ± Rating outlook ± Credit watch
Describe briefly the regulatory framework for credit rating agencies in India ? Describe some of the important eligibility criteria for a rating agency ?
Questions for Revision
What is the methodology followed by Rating agencies in India for Industry ? What are the basic factors considered while assessing a state ? Write short Notes on
± ± ± ± CRISIL ICRA CARE Fitch Ratings India
Questions for Revision
What is the difference between obligor default rating (ODR) and loss given default rating (LGDR)? Write a short Note on Internal Risk Rating?
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