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EXTERNAL RATINGS



Category: Risk Management in Banking

The main, or global, rating agencies are Moodys, Standard & Poors (S&P) and Fitch. Ratings are assessments of the credit standing of a debt issue, materialized by coded letters (such as Aaa, Aa, etc.) that serve essentially the needs of investors to have a third party view on the credit risk of debt. In addition, ratings rank risk rather than value risk. This is a major distinction between ratings and default probabilities, the latter being a quantification of the default likelihood of a debt issuer.

Rating agencies rate public issues rather than issuers. The same issuer usually has several debt issues, not all of them having the same risk. They all share the risk that the issuer defaults. However, issues differ by seniority levels and guarantees. Senior unsecured ratings are very close to issuer ratings because they benefit from first priority repayments in the event of default. Hence, the likelihood of loss is similar to the default likelihood of the issuer. Secured debts have collateral attached so that, in the event of default of the issuer, they benefit from higher recoveries. Subordinated debts are subject to claims from more senior lenders and have a higher risk. Therefore, the credit risk varies across debt issues of the same issuer, even though they all share the same default risk, which is specific to the issuer. Because senior unsecured debt is first to be repaid and does not benefit from any collateral other than the credit standing of the issuer, it is possible to consider senior unsecured debt ratings as issuers ratings.

Ratings depend on fundamental analysis under a long-term view. Agencies tend to rate through the cycle based on the long-term view of strengths and weaknesses, opportunities and threats (SWOT) of firms. Hence, ratings do not change frequently under normal conditions because short-term deviations due to current conditions are not relevant as long as they do not alter durably the credit standing of an obligor. However, agencies continuously review their ratings on a periodical basis or under occurrence of contingent events that affect the credit standing of an issuer. An example of such an event is a merger or an acquisition, which changes significantly the risk profile of a corporate borrower. Rating agencies also provide short-term ratings and signal ratings under review to investors.

External ratings apply to various debt issues from: corporate firms; banks and financial institutions; sovereign borrowers (country risk); multilateral development banks. Ratings also apply to currencies, including local currency and foreign currency held locally and subject to transfer risk, the risk of being unable to transfer cash out of the country. By contrast, an issuers rating characterizes the credit standing of an issuer and should correlate with its default probability.

Ratings from agencies exist only for issues of large listed companies. This creates a bias when assigning default frequencies based on historical default statistics because the sample of counterparties rated by agencies is usually not representative of the banks portfolios. For bank corporate loans or market counterparties, external agency ratings are usually not available because borrowers are medium or small businesses. Banks need to rely on their own internal rating schemes to differentiate the risk of their exposures to these counterparties.

Internal rating scales differentiate investment grade and speculative grade (riskier) ratings. Moodys simplified rating scale uses three levels for investment grade ratings and the next three levels are speculative grade. Detailed scales include 20 levels, excluding the near default states, for Moodys, S&P and Fitch. The next chapter shows how to map rating scales with historical data on default and migrations. It shows that default frequencies increase drastically when ratings move down along the scale (towards riskier classes).

In general, a typical rating scale uses such general qualifications of credit risk as highest, high grade, some risk or vulnerable, highly vulnerable. The qualifications of various levels do not make fully explicit the criteria used for ratings, although all agencies provide methodology notes. This makes sense given that there is a wide variety of criteria influencing the credit standing of a borrower.


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