Credit
Rating
Chapter 6
Credit Rating
▪ Broad Definition of Risk in Banking: Risk in banking is defined as the
probability of loss due to adverse deviations from planned outcomes, affecting
both the bank and its customers.
▪ Credit Risk as a Primary Concern: Credit Risk, or Default Risk, arises from
a customer's inability or unwillingness to meet financial commitments,
including lending, trading, and settlement.
▪ External and Internal Factors Influencing Credit Risk: Credit risk is
influenced by external factors like economic conditions and internal factors
such as deficiencies in loan policies and inadequate risk management
practices.
▪ Counterparty Risk: Counterparty risk, a variant of credit risk, occurs when
trading partners fail to perform due to adverse price movements or unforeseen
external constraints.
▪ RBI Guidelines on Risk Management: The RBI has emphasized the need
for comprehensive risk management systems in banks, with a particular focus
on credit risk management, urging top management to prioritize this area.
RBI guidelines on credit risk management
(a) Measure risk through credit rating/scoring
For this purpose, the banks should:
▪ Set up a comprehensive risk scoring system capable of
assessing borrowers on parameters like industry risk,
business risk, financial risk, and management risk.
▪ Clearly define rating threshold below which the bank will
not lend.
▪ Conduct periodic (quarterly/half-yearly) review of ratings.
▪ Based on periodic reviews, map the rating migrations.
RBI guidelines on credit risk management
(b) Quantify the credit risk
For this purpose, the banks should:
▪ Estimate the expected credit loss based on past
behavior of the customers and portfolio; and
▪ Determine the extent of unexpected loss based on
variations in past behavior.
RBI guidelines on credit risk management
(c) Price the risk in a scientific manner
For this purpose, the banks should:
▪ Price loans in such a way to cover the expected loss
using the ‘Risk Adjusted Return On Capital’ (RAROC)
framework; and
▪ Allocate economic capital based on the extent of
unexpected loss.
RBI guidelines on credit risk management
(d) Monitor and control risk
For this purpose, the banks should:
▪ Identify loans with credit weaknesses to proactively isolate problem
areas. This will help in better follow-up of such accounts.
▪ Determine adequacy of provisions based on expected loss estimates.
▪ Stipulate rating-wise limits on loan exposure and target volumes based
on risk rating.
▪ Undertake loan portfolio reviews on an ongoing basis to assess the
quality of the portfolio and facilitate new loan origination processes.
▪ Assess adherence to policies and procedures and conduct periodic top
management reporting.
WHAT IS CREDIT RATING?
▪ Definition of Credit Rating: Credit rating is a grade
assigned to an individual or entity to assess their ability to
repay debts, influencing lending decisions and interest rates.
▪ Mandatory Credit Rating: Regulatory requirements
mandate credit ratings for corporate exposures, with banks
encouraged to use external ratings to manage capital
efficiency.
▪ Impact of Credit Rating on Lending: Higher credit ratings
enable borrowers to access larger loan amounts and lower
interest rates, reflecting reduced credit risk.
▪ Credit Risk Assessment: The level of credit risk varies
between loan proposals, even for similar projects or the same
promoters, based on unique features of each proposal.
OBJECTIVES OF RATING
The main objectives of credit rating in respect of appraisal of a
credit proposal are:—
(a) To decide about accepting, rejecting the proposal or
accepting the same with modifications/special covenants.
(b) To determine the pricing, the rate of interest to be charged.
(c) To help in the macro evaluation of the banks' credit portfolio
by classifying it on the ratings allotted to individual accounts.
This matrix is used for assessing the provisioning requirements,
as also for reviewing the loan policy of the bank.
INTERNAL AND EXTERNAL RATINGS
Most of the banks in India have developed their own credit rating models.
List of such agencies accredited by RBI: International Agencies
(Where specified)
Acuite Ratings & Research Limited (Acuite); (a) Fitch
b. Credit Analysis and Research Limited (CARE); (b) Moody's; and
c. CRISIL Ratings Limited; (c) Standard & Poor's
d. ICRA Limited;
e. India Ratings and Research Private Limited (India Ratings); and
f. INFOMERICS Valuation and Rating Pvt. Ltd. (INFOMERICS)
A simple Model Credit Rating
▪ In respect of medium size companies, the simple model measures the basic
financial health parameters of the company.
▪ The financial ratios are computed for the target company as per its latest
audited balance sheet.
▪ The company’s ratios are then compared with that of an extremely healthy
company so as to arrive at the credit rating.
▪ As the Balance Sheet figures would give the picture on a particular date only,
the rater studies the movement of the ratios over the period of two or three
years (internal comparison) vis-a-vis the industry average (external
comparison).
▪ After assigning suitable marks for these comparative figures, the final marks,
obtained by a company are evaluated, with the maximum for any company
being 100.
Item Ratio-range Maximum score Company's ratio Company's score
Methodology Current Ratio Over 1.50
1.33 to 1.50
20
16
1.34 16
of Simple 1.20 to 1.33 12
Credit Rating 1.10 to 1.20 8
1.00 to 1.10 4
Below 1.00 0
TOL/TNW Below 3.00 20 3.20 16
3.00 to 3.50 16
3.50 to 4.00 12
4.00 to 4.25 8
4.25 to 4.50 4
Above 4.50 0
PBIT/Interest Over 3.00 20 2.40 6
2.50 to 3.00 10
2.00 to 2.50 8
1.75 to 2.00 6
1.50 to 1.75 4
Below 1.50 0
PAT/Net Sales Above 15% 10 10 4
13-15% 8
11-12% 6
9-10% 4
7-8% 2
Less than 6% 0
Internal Comparison
▪ The objective of the comparison is to find if there is growth and improvement
or otherwise in the ratios, for example, an improvement in the current ratio
could be awarded, say 2 marks and 0 marks if there is deterioration.
▪ As the simple model is based on overall score it is possible to consider
negative marks if there is marked deterioration.
▪ DER could be evaluated in a similar manner. Further if PAT/Net Sales improves
over a period of 2/3 years 3 marks could be reckoned and if it remains the
same 1 mark and 0 mark if it has worsened.
External Comparison
▪ Herein, comparison of the borrower company’s performance is made
with the data on Industry.
▪ Generally, a performance over a three year period is made in respect of
Current Ratio, DER, Profitability Ratio and holding of inventory &
receivable to sales of the industry average.
▪ Higher marks are allotted for improvement and for maintenance of the
same level of ratios.
▪ 0 or negative marks are given for worsening situation.The above
simplified model can be refined by assessing the quality of the numbers
underlying the ratios.
▪ It is possible to add more ratios and add one or two critical areas for
rating.
Addition of complexities
• Industry profile may be studied from the following angles:
• (i) Competition and Market Risk
(ii) Cyclicality
(iii) Regulatory, Labour and Environmental Risks
(iv) User Profile
(v) Inputs Profile
Addition of complexities
• The management quality may be examined using the following parameters:
• (a) Competence
(b) Professionalism
(c) Integrity
(d) Track Record
(e) Structure and Systems
SCOPE OF APPLICATION OF EXTERNAL RATINGS
▪ Consistency in Credit Rating Usage: Banks must consistently use the ratings
of chosen credit rating agencies for each type of claim, avoiding selective or
arbitrary use of different agencies.
▪ Restriction on Cherry Picking Ratings: Banks cannot use different agencies'
ratings for separate exposures to the same counterparty unless only one
agency's rating is available for each exposure.
▪ Disclosure of Credit Rating Agencies: Banks must disclose the names of the
credit rating agencies they use, the risk weights associated with ratings, and their
aggregated risk-weighted assets.
▪ Entire Exposure Rating Requirement: For risk weighting, the external credit
rating must cover the entire amount of a bank’s claim; partial ratings are not
eligible.
▪ Public Availability of Ratings: Credit ratings must be publicly accessible and
included in the rating agency’s transition matrix to be eligible for risk weighting.
▪ ECAI Disclosure Requirement: If an ECAI does not disclose the rated credit
facilities in Press Reports, the rating cannot be used for capital computation, and
the exposure is treated as unrated with applicable risk weights.
