Welcome to Banking Quest

GIST OF DISCUSSION 

• Introduction to the Credit Rating system – why and how 
• Rating process in banks 
• How banks use risk rating
• Regulatory dimensions of credit rating system 
• Internal credit rating system 
• External credit rating 
• How it mitigates credit risk

WHAT IS THE CREDIT RATING 

• The term credit rating refers to a quantified assessment of a borrower's creditworthiness in general terms or with respect to a particular debt or financial obligation. 
• A credit rating can be assigned to any entity that seeks to borrow money—an individual, a corporation, a state or provincial authority, or a sovereign government.
• Individual credit scores can be calculated and arrived at (i) internally by lenders or by (ii) professional credit bureaus – approved credit rating agencies.

WHY CREDIT RATING IS NEEDED 

• One of the key functions of banks is to lend 
• The biggest risk in lending is credit risk 
• In order to mitigate credit risk, there has to be rigor in the credit origination process 
• In credit origination the credit appraisal system has to be robust. 
• As part of credit appraisal, banks have to understand the creditworthiness of the potential borrower to take credit decisions. 
• Internal or external credit rating is able to provide reliable information on the creditworthiness of the borrower. 
• Banks can make sense of the probability of default by looking at the credit rating of the borrower.

INPUTS NEEDED FOR ASSESSING CREDIT RATING 

• Potential borrower profile including financials – previous and projected 
• Underlying entrepreneurial business model – its viability and sustainability 
• Collaterals – primary and secondary 
• The net worth of the borrower 
• Viability of the activity – market demand 
• Business cycle position - at what stage the borrower is operating. 
• Macroeconomic indicators
• Market Intelligence data   

INTERNAL CREDIT RATING SYSTEM OF BANKS

• Internal Credit Risk Rating System refers to the system to analyze a borrower's repayment ability based on information about a customer's financial condition including its liquidity, cash flow, profitability, debt profile, market indicators, industry and operational background, management capabilities, and other indicators. 
• Credit rating derived from the internal credit rating process will be the key reference for credit risk assessment and decision-making.

LENDING AUTOMATION SYSTEM AUTOMATION OF THE CREDIT RATING PROCESS THE MORE GRANULAR THE DATA – THE BETTER IT IS

• Automation can mitigate the inconsistency and delays of manually collecting financial data and other mandatory borrower information. 
• Borrower-facing web-based portals and application program interfaces (APIs) can facilitate the digital onboarding of new prospects and existing borrower data straight to the lender’s loan origination platform. 
• After data is received, lender-defined business rules can automate the next step in the process, differentiating between loan applications that are ready for decision and loan applications that require more documentation.

INPUTS FOR ASSESSING CREDIT WORTHINESS OF EXISTING OR POTENTIAL BORROWER 

• Credit Ratings should be based on the following considerations: a) default likelihood of the debtor b) nature and provisions of the obligation c) dilution in the rights of the bank in the event of financial distress, under the laws affecting creditor's rights 
• Credit risk for counterparty arises from an aggregation of the following: a) External risk - sector risk (including government policies) b) Internal risk with respect to counterparty - business risk - financial risk - management risk - project risk 
• Any risk rating model would need to evaluate each of the above risks individually and aggregate the same to arrive at an overall rating measure.

CONCEPTUAL METHODOLOGY OF INTERNAL CREDIT RATING 

• Different approaches to the measurement of credit loss: 
• Most banks employ either of two conceptual definitions of credit loss: the default-mode paradigm, in which a credit loss arises only if a borrower defaults within the planning horizon, and the mark-to-market paradigm, in which credit deterioration short of default is also incorporated. 
• Banks may also choose to adopt different time horizons for monitoring credit risk. 
• Different methodologies for the measurement of exposure and loss given default: 
• In measuring exposure to a line of credit, some banks employ a largely judgmental approach for estimating recovery values of loans in the event of default, while others rely on more empirically based techniques.

CHALLENGES IN INTERNAL CREDIT RATING – I  

• The basic problems in developing models of credit risk are 
  • obtaining adequate data and
  • devising a satisfactory way of handling the variability of credit exposures.
• On data, banks face the difficulty that they have only recently begun to collect relevant information in a systematic manner. 
• Many do not even know simple facts about defaults in their loan books going back in time.  Although serious, this difficulty is transitional and will be mitigated as time goes by and perhaps also as banks make arrangements to share data. 

CHALLENGES IN INTERNAL CREDIT RATING – II 

• The more serious data problem is that bank loans and even many corporate bonds are either partly or totally illiquid and mark-to-market values are therefore not available. 
• This means that one must rely on some other measure of value in order to establish and track the riskiness of credit-sensitive exposures. 
• The next major problem faced by credit risk analysis is that of modeling the covariation in credit risk across different exposures. 

EXTERNAL CREDIT RATING OF BORROWERS

• The concept and meaning of external credit rating can be understood by looking at some definitions offered by well-known credit rating agencies. 
• ICRA: “Ratings are opinions on the relative capability of timely servicing of corporate debt and obligations. These are not recommendations to buy or sell; neither the accuracy nor the completeness of the information is guaranteed.”
• Moody’: “Ratings are designed exclusively for the purpose of grading borrowers according to their intrinsic financial capabilities.”

CREDIT RISK RATING FRAMEWORK  (CRF)

• It is indicated by a number/ alphabet/ symbol as a primary summary indicator of risks associated with credit exposure. 
• The underlying logic for a CRF is the limitations associated with a binary classification of loans/exposures reflecting the pulse of the probability of default. 
• Such a rating framework is the basic module for developing a credit risk management system and all advanced models/approaches are based on this structure. 

VALIDATION OF INTERNAL CREDIT RATING PROCESS – UNDER BASEL – II SUPERVISORY REVIEW PROCESS – I 

• If internal models were to be used in setting regulatory capital requirements, regulators would need some means of ensuring that a bank’s internal model accurately represents the level of risk inherent in the portfolio and the required regulatory capital. 
• At present, there is no commonly accepted framework for periodically verifying the accuracy of credit risk models and in future methods such as sensitivity testing are likely to play an important role in this process. 

RATING OF BORROWERS AND RISK WEIGHTS – I 

• Risk weight is the foundation on which the capital adequacy ratio is assessed
• In loans linked to repo rates/MCLR that are low ticket are assigned risk weight as per RBI guidelines. For example, individual housing loans used to carry a risk weight of 35 if their loan-to-value (LTV) ratio is 80 percent or lower but later moved to the staggered pattern.  
• Priority sector loans of different sectors carry different risk weights as per RBI. 
• These are mostly applied on an aggregate portfolio basis.  Same risk weight for all loans. 

RATING OF BORROWERS AND RISK WEIGHTS – II 

• But larger loans – Rs. 5 crores and above are critical for banks. 
• If a bank wants the risk weight to align with the risk rating, it has to be from an external rating agency duly approved by RBI. 
• If suppose, you have a loan account of Rs. 100 crores given to ABC associates whose credit rating is AAA, the risk weight can be 20 as per RBI but banks cannot load unless the approved rating agency incorporates the name of the bank in its rating disclosure.
• But if the external credit rating is done, and if the borrower has superior credit rating, banks can accordingly compute risk weight and CAR will improve 
• Hence in large loan accounts commercial banks prefer to get the external credit rating as per a uniform credit risk management policy of the bank. 

RATING OF BORROWERS AND RISK WEIGHTS – III 

• Hence, going beyond the internal credit rating system, if the banks opt for an external credit rating agency and if the borrower obtains a better rating, the risk weight can come down and banks will be benefitted. 
• But such external credit rating and its corresponding risk weight have to be approved by RBI under Basel –II supervisory review process (SRP).
• Since risk weight and CAR form part of the Internal capital adequacy assessment policy  ICAAP needs to be approved by RBI. If there is no external rating banks have to apply risk weights according to the RBI template. 

VALIDATION OF INTERNAL CREDIT RATING PROCESS – UNDER BASEL – II SUPERVISORY REVIEW PROCESS – I 

• It is important to note that the internal environment in which a model operates – including the amount of management oversight, the quality of internal controls, the rigor of stress testing, the reporting process, and other traditional features of the credit culture – will also continue to play a key part in the evaluation of a bank’s risk management framework. 
• Estimation of some model parameters, such as the assignment of an internal loan grading or assignment of an obligor to one or more industry sectors, may also require some judgment.

INTERNAL RATING SYSTEM 

• After providing inputs to the balance sheet, profit and loss statement, cash flow statement and qualitative analysis, the detail management report and executive summary report will automatically be generated. 
• In the detail management report there could be four color coding is used. 
• The detail of the color coding is usually as follows: 
• Color Rating Green - Excellent 
• Blue - Good 
• Yellow - Marginal 
• Red - Unacceptable
•  The analyst should meticulously review all color coding and rating. For the quantitative and qualitative risk analysis, if the ICRR falls under "Marginal" or "Unacceptable" for any risk criteria (among 16 quantitative and 18 qualitative); whatever the aggregate score is, the relationship manager shall evaluate what would be the impacts of such risk on loan repayment and justify how those risks are mitigated; and in loan proposal, the approval authority should review that justifications thoroughly and make necessary evaluations on it and should be documented in the loan file
  

CREDIT RATING BY EXTERNAL RATING AGENCIES – I 

• It is an assessment by an independent agency of the capacity to pay interest and repay the principal as per the terms of credit granted by lenders. 
• The ratings are expressed in code numbers which can be easily comprehended even by the new investors/lenders 
• Credit rating is only a guideline to the investors/lenders and not a recommendation for a particular debt instrument.
• The important elements for investing in debt securities are (a) yield to maturity (b) risk tolerance to investors and (c) credit risk of the security. The opinion of the credit rating agencies is considered on any of the above three aspects

CREDIT RATING BY EXTERNAL RATING AGENCIES – II

• Credit rating is an ongoing appraisal. 
• A rating is a one-time evaluation of credit risk. 
• Changes in the dynamic world of business may imply changes in the risk characteristics of the security.
• A credit rating does not create a fiduciary relationship between agencies giving the ratings and the people using the ratings as there is no legal basis for such a relationship.

PURPOSE OF CREDIT RATING – I 

• Credit ratings establish a link between risk and return. 
• In risk-based pricing, banks load risk premiums based on the credit rating assigned by the credit rating agency. 
• They thus provide a yardstick against which to measure the risk intrinsic in any instrument. 
• An investor/lender takes help from the ratings to assess the risk level and compares the offered rate of return with his expected rate of return (for the particular level of risk) to optimize his risk-return trade-off. 
• The lender or investor may not possess the requisite skills of credit risk evaluation. Thus, the need for credit rating in today’s world cannot be exaggerated. It is of abundant assistance to investors in making investment decisions. 

PURPOSE OF EXTERNAL CREDIT RATING – II

• RBI has stipulated a minimum credit rating by an approved agency for the issue of commercial paper. 
• In general, credit rating is expected to improve quality consciousness in the market and establish over a period of time, a more meaningful relationship between the quality of debt and the yield from it.
• Credit Rating is also a valuable input in establishing business relationships of various types. However, credit rating by a rating agency should not be taken as a recommendation to purchase or sell a security. 
• Investors usually follow security ratings while making investments. Ratings are considered to be an objective evaluation of the probability that a borrower will default on a given security issue, by the investors. 

RBI APPROVED EXTERNAL CREDIT RATING AGENCIES 

• In January 2023, RBI advised banks to use the ratings of the following domestic credit rating agencies for risk weighting their claims for capital adequacy purposes.

1. Acuite Ratings & Research Limited (Acuite), 
2. Credit Analysis and Research Limited (CARE); 
3. CRISIL Ratings Limited 
4. ICRA Limited,
5. India Ratings, Research Private Limited (India Ratings);
6. INFOMERICS Valuation and Rating Pvt Ltd.

CREDIT RATING IS A DISTINCT INDICATOR OF CREDIT WORTHINESS WITH ASSURANCE TO WATCH THE LOAN ACCOUNT

• A credit rating is a quantified assessment of the creditworthiness of a borrower in general terms or with respect to a financial obligation.
• Credit ratings determine whether a borrower is approved for credit as well as the interest rate at which it will be repaid.
• A credit rating or score is assigned to any entity that wants to borrow money—an individual, a corporation, a state or provincial authority, or a sovereign government.
• Credit for individual consumers is rated on a numeric scale based on the FICO calculation by credit bureaus.
• Bonds issued by businesses and governments are rated by credit agencies on a letter-based system ranging from AAA to D.

WHY RATING OF BORROWERS ESSENTIAL 

• A credit rating helps lenders determine a borrower’s creditworthiness.
• Personal credit ratings are determined by factors such as the history of taking account loans, loan balances, and payment history.
• Investors often base their decisions about whether to buy a bond and sometimes stock, based on the company's credit rating.
• Countries with higher credit ratings are more likely to attract bond buyers in the form of foreign capital.

CRF LEADS TO STANDARDISATION 

• These frameworks have been primarily driven by a need to standardize and uniformly communicate the “judgment” in credit selection procedures. 
• The point here is that these rating frameworks, which are logic-based and utilize responses made on a specified scale, promote the accuracy and consistency of the judgment exercised by the banks/FIs and are not a substitute for the vast lending experience accumulated by their professional staff.

BASIC ARCHITECTURE OF CRF

• Grading: Expressed into a grading system for calibration of credit risk. Nature of grading system. The number of grades used. Further refinements in the grading system.
• Operating design of CRF: Which exposures are rated?? Rating process, credit approval, and surveillance procedures? Functional responsibilities for the CRF? Operating the CRF system. The formality of procedures and communications? CRF and the credit culture
• Follow on activities: Aggregated credit risk profile and CRFs. Portfolio surveillance and reporting. Provisioning and reserve creation. Profitability and risk mapping of credit products. Guidelines for pricing and asset buildup. Dynamic asset portfolio management.

STEPS IN CREDIT RATING 

1. Identify all the principal business and financial risk elements Step 
2. Allocate weights to principal risk components 
3. Compare with weights given in similar sectors and check for consistency 
4. Establish the key parameters (sub-components of the principal risk elements) 
5. Assign weightage to each of the key parameters 
6. Rank the key parameters on the specified scale 
7. Arrive at the credit-risk rating on the CRF 
8. Compare with previous risk ratings of similar exposures and check for consistency 
9. Conclude the credit-risk calibration on the CRF 

STANDARDIZATION AND BENCHMARKS FOR RISK-RATINGS

• In a lending environment dominated by industrial and corporate credits, the assignors of risk ratings utilize benchmarks or pre-specified standards for assessing the risk profile of a potential borrower. 
• These standards usually consist of financial ratios and credit-migration statistics, which capture the financial risks posed by the potential borrower (e.g. operating and financial leverage, profitability, liquidity, and debt-servicing ability). 
• The business risks associated with an exposure (e.g. cyclicality of industry, threats of product or technology substitution, etc.) are also addressed in the CRF.
  

CRF LEADS TO BETTER CREDIT DECISION

• The calibration on the risk-grading scale is expected to define the pricing and related terms and conditions for the accepted credit exposures. It is possible to define broad pricing bands and directly link the band with the calibration on the risk-rating scale

CREDIT RATING WILL ENABLE RISK MITIGATION 

• Upon getting a credit rating the lender will decide whether to take exposure or not – at this stage itself, it is possible to lower the credit risk. 
• If the bank decides to lend – it will introspect into risk-based pricing 
• The lender will align the credit risk according to exposure levels and risk-based pricing 
• There will be a constant watch on the conduct of the loan accounts and the behavior of the borrower. 
• If the borrower is not repaying the dues in time, a special mention account system will capture the trend, and the branch can approach the borrower as part of regular credit appraisal.