Commercial Credit Risk Management

8/7/2019 Commercial Credit Risk Management

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Commercial credit risk is the largest and most

elementary risk faced by many banks,

and it is a major risk for many other kinds offinancial institutions and corporations as well.


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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.


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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


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Traditional approach

Creditrisk assessments

within an overall framework known as a credit

rating system


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To make a credit assessment

analysts must take into consideration

many complex attributes of a firmfinancial

and managerial, quantitative and qualitative.


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They must ascertain the financial health of the

firm,

determine whether earnings and cash flowsare sufficient to cover any debt obligations,

analyze the quality of the firms assets,

and examine its liquidity position.


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In addition, analysts must take into accountthe nature of the industry to which thepotential client belongs,

the status of their new client within thatindustry,

and the potential effect of macroeconomic

events on the firm (including any country risks, such as a political

upheaval or currency crisis).


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Well look first at how credit rating agencies

(key players in the development of modern

ratings) arrive at their public credit ratings of

large corporations.


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Then well take a look at how banks arrive at

their own private internal ratings of firms,

large and small, that lack a public credit rating.


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Internal risk rating systems are one of the

banking industrys 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 consistentframework and permit comparisons across the

entire loan portfolio.


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PURPOSEOFINTERNAL RISK RATING

SYSTEMS (IRRS)

Setting limits and acceptance or rejection of newtransactions.

The strength of the rating awarded to an entity or

transaction is likely to play a key role in thedecision to accept or reject a particulartransaction.

Credit-risk limits are often set in terms of ratingcategories.

Also, concentration limits by name, industry, andcountry are established and revised annually bythe senior risk committee of the bank.


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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 assessmentof a borrower.

Credit migration is a critical component in

monitoring the credit quality of the loan

portfolios of banks.


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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 firms activities and

portfolios.

Internal ratings are key input in the economic

capital allocation process to credit portfolios.


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Risk adjusted return on capital

(RA

RO

C) 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 andoperational risks and is often calculated by Var.


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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 accounting-

based reserve for loan losses

and the provision for losses in the currentaccounting period.


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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.


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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


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RATINGAGENCIES


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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 Moodys (1909), Standard

& Poors (1916), and other agencies started to

offer independent assessments of how likely it

was that particular bonds would repayinvestors in the way they were intended to do.


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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 & Poors (S&P) was the first rating

company to rate mortgage-backed bonds

(1975), mutual funds (1983), and asset-backedsecurities (1985).


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A credit rating is not, in general, an investment

recommendation for a given security.

When rating a security, a rating agencyfocuses more on the potential downside loss

than on the potential upside gain.


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In the words ofS&P

A credit rating is S&Ps 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.


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In Moodys 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.


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S&P and Moodys have access to a

corporations internal information,

and since they are considered to haveexpertise in credit rating and are generally

regarded as unbiased evaluators,

their ratings are widely accepted by market

participants and regulatory agencies.


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Financial institutions, when required by their

regulators to hold investment-grade bonds,

use the ratings of credit agencies such asS

&P

and Moodys to determine which bonds are of

investment grade.


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There are two main classes of ratings

With issuer credit ratings,

the rating is an opinion on the obligors overall

capacity to meet its financial obligations. In the issuer credit rating category are

counterparty ratings, corporate credit ratings,

and sovereign credit ratings.


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Issue-specific credit ratings

Another class of rating is issue-specific creditratings.

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.


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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.


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The rating process includes quantitative, qualitative,and legal analyses.

The quantitative analysis is mainly financial analysis

and is based on the firms financial reports. The qualitative analysis is concerned with the quality of

management;

it includes a thorough review of the firmscompetitiveness within its industry as well as theexpected growth of the industry

and its vulnerability to business cycles, technologicalchanges, regulatory changes, and labor relations.


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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.


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The assessment of management, which is

subjective in nature, investigates

how likely it is that management will achieveoperational 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.


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All the information is reviewed and discussedby a rating committee with appropriateexpertise 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 sixweeks after the agency is asked to rate a debt

issue.


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Moodys Rating Analysis of an

Industrial Company

Issue Structure

Company Structure

Operating/Financial Position Management Quality

Industry/Regulatory Trends

Sovereign/Macroeconomic Analysis


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Usually the ratings are reviewed once a yearbased on new financial reports, new businessinformation, and review meetings with

management. Acredit watch or rating review notice is

issued if there is reason to believe that thereview may lead to a credit rating change.

A change of rating has to be approved by therating committee.


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Credit Ratings by S&P and Moodys

Standard & Poors (S&P) is one of the worlds

major rating agencies, operating in more than

50 countries.

Moodys operates mainly in the United States

but has many branches internationally


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Issues rated in the four highest categories (i.e.,

AAA, AA, A, and BBB for S&P

andA

aa,A

a,A

, andB

aa for Moodys) are generally considered to be of investment

grade.


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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 Moodys) are regarded

as having significant speculative characteristics. BB (Ba in Moodys) is the least risky, and C is the

most risky.


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S&P uses plus or minus signs to modify its AA to CCCratings in order to indicate the relative standing of acredit within the major rating categories.

S

imilarly, Moodys applies numerical modifiers 1, 2,and 3 in each generic rating classification from Aathrough Caa.

The modifier 1, for example, indicates that theobligation ranks at the higher end of its generic rating

category;

thus B1 in Moodys rating system is a rankingequivalent to B! in S&Ps rating system.


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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.


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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.


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While the major rating agencies use similar methodsand approaches to rate debt, they sometimes come upwith different ratings for the same debt investment.

A

cademic studies of the credit rating industry haveshown that only just over half of the firms rated AA orAa and AAA or Aaa in a large sample were rated thesame 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 andMoodys; only rarely do they award a lower rating


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DEBT RATINGAND 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 processthe moment

when it is finally recognized that a firm cannot

meet its financial obligations.


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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.


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INTERNAL RISK RATING

banks are in the business of lending money toa very wide spectrum of companies, not justthose that issue public debt (and that

therefore find it useful to invest in gaining acredit rating).

Many smaller and private companies are noteven listed on a public stock exchange, so thatmuch of the financial data that can begathered about them are of unproven quality.


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Typically, a bank IRRS assigns two kinds of ratings.First, it assigns an obligor default rating (ODR) toeach borrower (or group of borrowers)

that identifies the borrowers probability ofdefault.

Second, it assigns a loss given default rating(LGDR) to each available facility,

independently of the ODR, that identifies the riskof loss from that facility in the event of default onthe obligation.


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To understand the fundamental difference betweenthese two kinds of rating, lets consider the keyconcept ofexpected loss.

The expectedloss 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 anyspecific credit facility. In this example, the

expected loss is $100 * 0.02 * 0.50 = $1.


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The ODR represents simply the probability ofdefault by a borrower in repaying its obligation inthe normal course of business.

The LGDR, on the other hand, assesses theconditional severity of the loss, should defaultoccur.

The severity of the loss on any facility is

considerably influenced by whether the bank hasput in place risk mitigation tools such asguarantees, collateral, and so on.


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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 risk-

adjusted return on capital (RAROC) systems


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Steps in the IRRS

FINANCIALASSESSMENT (STEP 1)


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Introduction

This step formalizes the thinking process of agood credit analyst (or good equity analyst),whose goal is to ascertain the financial health ofan institution.

The credit analyst might begin by studying theinstitutions financial reports to determinewhether the earnings and cash flows aresufficient to cover the debt repayments.

The credit analyst will study the degree to whichthe trends associated with these financials arestable and positive.


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The credit analyst will also want to analyze thecompanys assets to determine whether they are ofhigh 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 firms

leverage.

Similarly, the credit analyst will want to analyze theextent to which the firm has access to the capitalmarkets,

and whether it is able to borrow the money that it willneed to carry out its business plans.


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The rating should reflect the companys

financial position and performance and its

ability to withstand any financial setbacks.


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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.


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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


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The analysis would emphasize the current

years 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 isincorporated.


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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.


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When assessing the financial size, flexibility,

and debt capacity category,

the size of the market capitalization will be an

important factor.


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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.


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Industry Benchmarks

The analysis of a firms competitive position

and operating environment helps in assessing

the firms general business risk profile.

This profile can be used to calibrate

quantitative information drawn from the

financial ratios for the firm,


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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 borrowers management.

Step 2 analysis may bring about a downgrade

if standards are not acceptable.


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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


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For example, in the case of day-to-day account

operations, is the firms 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?


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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 andappropriate 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?


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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?


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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.


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using an industry assessment (IA) ratings scheme foreach industry.

To calculate the industry assessment, the analyst firstassigns a score of 1 (minimal risk) to 5 (very high risk)

for each of a set of, say, eight criteria established by thebank.

For example, each industry might be described interms of its competitiveness, trade environment,regulatory framework, restructuring, technological

change, financial performance, long-term trendsaffecting demand, and vulnerability to macroeconomicenvironment.


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Tier Assessment (Step 3b)

The criteria and process used to assess industry riskcan often be reapplied to determine a companysrelative position (say, on a scale of tiers 1 to 4) withinan industry.

A business should be ranked against its appropriatecompetition.

That is, if the company supplies a product or servicethat is subject to global competition, then it should beranked on a global basis.

If the companys competitors are by nature local orregional, as is the casefor many retail businesses, thenit should be ranked on that basis


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In a four-tier system, tier 1 players are major playerswith 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 onsustainable 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, tradingenvironment, technology, demand patterns, andmacroeconomic environment.


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Tier 2 players are important or above-average industryplayers 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 relevantmarket (local, regional, domestic, international, orniche).

Tier 4 players are weak industry players with adeclining customer base.

They have a high cost of production as a result offactors such as low leverage with suppliers, obsoletetechnologies, and so on.


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Industry/Tier Position (Step 3c)

This final part of the third step (Step 3c) combines theassessments of the health of the industry (i.e., theindustry rating) and the position of a business within itsindustry (i.e., the tier rating).

While the tier rating can be lowered if the industry/tierassessment is weak, it will not be raised if this positionis strong.

The process reveals the vulnerability of a company,particularly during recessions.

Low-quartile competitors within an industry classalmost always have higher risk (modified by therelative health of the industry).


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Financial Statement Quality (Step 4)

This fourth step recognizes the importance of thequality of the financial information provided tothe analyst.

This includes consideration of the size andcapabilities of the accounting firm compared tothe size and complexities of the borrower and itsfinancial 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.


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Country Risk (Step 5)

This fifth step adjusts for the effect of any country risk.

Country risk is the risk that a counterparty or obligorwill not be able to pay its obligations because of cross-border restrictions on the convertibility or availabilityof a given currency.

It is also an assessment of the political and economicrisk of a country.

Country risk exists when more than a prescribed

percentage (say 25 percent) of the obligors (gross)cash flow (or assets) is located outside of the localmarket.


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Country risk may be mitigated by hard currencycash flow received or earned by the counterparty.

Hard currency cash flow refers to revenue in a

major (i.e., readily exchanged) internationalcurrency (primarily U.S. and Canadian dollars,sterling, euro, and Japanese yen).

Again, Step 5 limits the best possible rating. For

example, if the clients operation has a countryrating in the fair category, then the bestpossible obligor rating might be limited to 5.

C i t E t l R ti (St


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Comparison to External Ratings (Step

6)

When the obligor is rated by an external ratingagency or when it is included in the database ofan external service providing default probability

estimates, such asK

MV, the preliminaryO

DRproduced in Step 5 is compared to these externalratings.

The intent is not to align the internal rating with

that of an external agency but to ensure that allappropriate risk issues have been factored intothe final ODR.


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When the ODR differs substantially from theexternal rating, then the rater should reviewthe assessment on which the rating process is

based (Steps 1 to 5). If the comparison suggests that important risk

factors were overlooked or underestimated inthe preliminary analysis, then these factors

should be incorporated in the final ODR byrevising Steps 1 through 5.


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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.


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Loan Structure (Step 7)

The risk rating process (Steps 1 through 6) assumesthat most credits have an appropriate loan structure inplace.

If so, Step 7 has no impact on the ODR.

However, if the loan structure is not sufficiently strongand is viewedas having a negative impact on the risk ofdefault 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 loanstructure should be to be regarded as appropriate.


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The components of the loan structure that may affectdefault risk are the financial covenants, the term of thedebt, its amortization scheme, and change-of-controlrestrictions.

For example, in the case of high-risk companies,financial ratio requirements should be progressive andshould fit tightly with the companys own forecasts.

In addition, significant amortization of debt over the

tenure of the facilities should be imposed, andnonmerger restrictions should be put in place.


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LOSSGIVEN DEFAULT RATING (LGDR)

Step 8 assigns a loss given default rating to each facility.This rating is determined independently of defaultprobabilities.

The probability of default and the loss experienced in

the event of default are separate risk issues andtherefore should be looked at independently.

Typically, each LGDR is mapped to an LGD factor, i.e., anumber between 0 and 100 percent, with 0 percentcorresponding to the case of total recovery and 100

percent to the situation where the creditor loses all theamount due.

The LGD should be calculated net of the recovery cost.


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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 theseverity of the loss given default for any facility.

The quality and depth of security varies widely

and will determine the extent of the benefit inreducing any loss.


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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.


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Collateral can have a major effect on the final LGDR,but the value of collateral is often far fromstraightforward.

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 toa property developer has a strong tendency to lose its

value during a property downturnthe moment in thesector cycle when a property developer is most likelyto default.


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the new Basel Capital Accord (Basel II) puts a

special emphasis on the internal ratingbased

approach for creditrisk attribution.

In the future, many banks will be able to use theirinternal 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.


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The history of the ratings industry began in the USA

in the late 19th century with the building of the

countrys railway system.

The debt instruments issued by the various railwayswere 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.


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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).


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Gradually, the mercantile rating agencies

began providing ratings on other financial

instruments and securities like bonds, bank

deposits and commercial papers.

Moodys began by rating railroad bonds

(1909), and a year later, extended its ratings

activity to utility and industrial bonds.


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The Fitch Publishing Company was established

in 1924.

Standard & Poors (S&P) was formed with the

merger ofPoor's Publishing Company and

Standard Statistics Company in 1941.


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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.


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The three primary rating agencies are as follows:

1. Moodys Investor Service

2. Standard & Poors

3. Fitch


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Moodys and S&P are generally considered the

most influential because they have the widest

geographical coverage.


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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


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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

Moodys 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.


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2. The sale of research, software, and other

proprietary information.


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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 istantamount to signaling the very poorest of

investment quality.


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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 norating 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 issuers favor by signaling to themarket that the issue deserves favorable pricing.


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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 foraccuracy and independence.


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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

issuers breaching its financial contract.


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Large companies with strong and stable cash

flows are likely to be rated higher than small

companies with more volatile cash flows.


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Investment grade refers to the safest levels of

financial securities.

Investment-grade securities have historically

exhibited relatively low rates of default.


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Speculative grade, or noninvestment grade,

refers to the riskier securities.

Debt rated BB (Ba for Moodys) or below is

noninvestment grade, and is sometimesreferred to as high yield or junk.

Default rates among these classes of securities

are comparatively high.


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Within the major rating categories (AA, A,

etc.), credit ratings are often modified to show

relative standing within a category.

Moodys uses numbers 1, 2, and 3, while S&Pand Fitch use plus (+) and minus () signs.

For example the three tiers of the triple B category are as


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For example, the three tiers of the triple-B category are as

follows:

Moody's S&P Fitch

Baa1 BBB+ BBB+

Baa2 BBB BBB

Baa3 BBB- BBBIntermediate

N hi


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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 companys

capital structure.


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For example, senior debt has priority over

subordinated debt in bankruptcy and will

therefore receive a higher rating.

Similarly, secured debt will receive a higherrating over unsecured debt because of its

senior claim.


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A specific example is CSX Corporation, a

transportation company headquartered in

Richmond, Virginia,

which received a Moodys rating for its equipmenttrust certificates (secured debt) ofA1, 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 notchbelow its senior debt.

R ti O tl k


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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 Moodys Review or

S&Ps 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 oras soon as the situation has been resolved.

Th R ti P


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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 companys operating andfinancial performance and outlook, and a host of

other factors that might affect the rating.

The companys chief financial officer is the main

participant in these discussions, with the chiefexecutive officer participating in any strategy

discussions.


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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

managements 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 agencys analysis, projections, and opinions may vary from

those of the companys management or their investment bankers.


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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 isnotified and the rationale behind the rating is

explained.

A rating is often assigned within two weeks,

depending on the nature of the proposedtransaction, the current demand for ratings by other

issuers, and the urgency of the companys request.


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Both Moodys 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 additionaldata supporting a higher rating.

After the final rating is assigned, the industry

analyst tracks the companys performance andadjusts the rating, as appropriate, over time.


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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 companysdevelopment.

Rating Methodology


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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.


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Because ratings are relative measures of

default risk,

it is not surprising that companies with

stronger financial measures have higherratings, on average.

The Role of Ratings in the Capital Markets


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The Role of Ratings in the Capital Markets

Ratings provide benefits to both issuers and

investors. Issuing companies with an investment-

grade 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 ratingsexpand their universe of potential investors

considerably.

For investors


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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 themost 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 insecurities below a certain rating.


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Standard & Poor's Sovereign Credit Ratings:

Scales and Process

S&Ps long-term credit-rating scale establishes a letter-


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grade hierarchy.

Ratings include AAA (extremely strong

repayment capacity);

AA (very strong);

A (strong);

BBB (adequate);

BB (less vulnerable);

B (more vulnerable);

CCC (currently vulnerable);


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CC (currently highly vulnerable);

R (under regulatory supervision owing to

its financial condition);

SD (selective default);

D (default);

and NR (not rated).


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Ratings ofBBB and above are considered

investment grade,

while ratings ofBB and below are non-

investment grade, or speculative grade.

Short term credit ratings


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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);


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R (under regulatory supervision);

SD (selective default);

D (default); and NR (not rated).

Rating Outlook


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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


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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.

CreditW

atch designations includepositive (rating

may beraised); negative (may be lowered); and developing

(may be raised, lowered, or affirmed).


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As with a rating Outlook, a CreditWatch listing

does not mean a rating change is inevitable,

and

conversely, rating changes may occur withoutthe ratings having first appeared on

CreditWatch.

Standard & Poor's Rating Process


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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 criteriaand requests a preliminary set of information from

the sovereign.


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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 [InternationalMonetary Fund] and the World Bank


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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 withrepresentatives of the finance ministry, central bank,

and other governmental agencies,

as well as individuals and organizations outside the

government who are well informed about economicand political trends in the country.


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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 eventualrating.

This report generally includes all of the

components of the eventual rating package indraft form.


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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


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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


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The rating committee considers both

quantitative and qualitative factors in

arriving at a rating decision.

The process involves ranking the sovereign bya one-to-six scale (one being the best) with

respect to each of 10 analytical categories,

though there is no exact formula forcombining the scores to determine ratings.


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Specific analytical categories include

political risk;

income and economic structure;

economic growth prospects;

fiscal flexibility;

general government debt burden;

off-budget and contingent liabilities;


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monetary flexibility;

external liquidity;

public-sector external debt burden;

and private sector external debt burden.


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The issue of political risk, a fundamentally

qualitative issue, distinguishes sovereigns

from most other types of issuers;

a sovereign has significant latitude simply tochoose not to repay even when able, leaving

creditors with limited legal redress.


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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


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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 ofEnron and WorldCom, revealed a complete

breakdown in all systems of internal control and external

monitoring.

The collapse of two mammoth organizations within a fewmonths of each other undermined the credibility ofU.S. credit

rating agencies.


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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.


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Even more than Enron, WorldCom was a skyrocket

that soared and then plunged.

By 2001, WorldComs 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 WorldComs debt

as investment-grade even three months before thecompany filed for bankruptcy.


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These scandals caused a lot of criticism and

public outcry against the efficiency of the

rating agencies.


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Credit Rating Agencies in India

There are four Credit Rating

i i I di


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agencies in India

CRISIL

ICRA

CARE and

Fitch India

Regulatory Framework


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g y

Credit Rating agencies are regulated by SEBI.

Registration with SEBI is mandatory for

carrying out the rating Business.

Promoter


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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


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g y

Is set up and registered as a company

Has specified rating activity as one of its main objects in its

Memorandum ofAssociation.

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 ofSEBI.

Has employed persons with adequate professional and otherrelevant experience, as per SEBI directions.

Grant of Certificate of Registration


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g

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


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The first rating agency Credit Rating

Information Services ofIndia Ltd. , CRISIL, was

promoted jointly in 1987 jointly by the ICICI

and the UTI.

ICRALtd


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Information and Credit Rating Services (ICRA)

has been promoted by IFCILtd 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 torisk management and regulatory practice.

CARELtd.


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Credit Analysis and Research Ltd or CARE is promoted by IDBIjointly 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 fieldof 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.


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g

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 andAlliance Group.

In addition to debt instruments, it also rates

companies and countries on request.

Rating Process


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g

Issue of rating request letter by the issuer of

the instrument and signing of the rating

agreement.

CRA assigns an analytical team consisting oftwo or more analysts one of whom would be

the lead analyst and serve as the primary

contact.


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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 supportingthe rating.


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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:


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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 dataavailable on the company.

Rating change


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Ts feel that there is a possibility ofOn

preliminary analysis of the new data, if the

analysts feel that there is a possibility of

changing the rating, then the analysts requestthe issuer for a meeting with its management

and proceed with a comprehensive rating

analysis.

Credit Rating Watch


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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 ratingchange.

In such a possibility, the issuers rating is put

on credit watch indicating the direction of apossible change and supporting reasons for

review.

Rating Methodology


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Business Analysis in terms ofIndustry Risk,Market position, operating efficiency and legal

position.

Financial analysis on the basis ofconsideration of accounting quality, earnings

protection and adequacy of cash flows.

Management Evaluation. Regulatory Environment.

Credit Rating ofIndian States


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Rating of the states by the CRISIL represents alandmark 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


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Economic structure of the state and itsfinances

Macroeconomic performance

Infrastructure

Sector studies

Whether revenue and expenditure patterns

are sustainable.

Deficit Management


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Degree of dependence on Central support

Tax policy of the state

Performance ofPublic sector undertakings

and their effect on the states finances.

Political Risk


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Relations between the state and the Centreand its impact on transfer of resources as well

as centres influence on political stability in

the state. Various political parties in the state, their

economic policies and their effect on the

states policies.


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Quality of the current leadership andadministration

Ability of the Government to take decisions

that are politically difficult.

Questions for Revision


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What is Credit Rating ? Describe how it startedand evolved ?

How do rating agencies generate their

revenue ? What is meant by

Investment grade securities

Speculative grade securities



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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 ratingagency ?



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What is the methodology followed by Ratingagencies in India for Industry ? What are the basic

factors considered while assessing a state ?

Write short Notes on

CRISIL

ICRA

CARE

Fitch Ratings

India



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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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The

End

Documents

Commercial Credit Risk Management