Chapter 7

Lim Chhayada

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• Introduction
• The Role of Credit Rating Systems
• Credit Risk Architectures
• Credit Rating
• External Rating
• Internal Rating
• Validating Credit Rating Systems
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 The role of credit rating systems has come to
play in managing credit risk for lenders.
 Rating systems have developed to provide
two basic components that are essential to
the credit process and risk management
practices.
 All transaction, whether good or bad, have
some level of default risk, the assumption is
that the degrees of risk can only be identified
through credit grades.
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 In most of the major big bank, credit rating
systems have become the cornerstone to
managing a ranges of credit functions that
serve to also provide a road map for
management decision making.
 Key risk indicators to assess creditworthiness,
credit rating systems also serve as the link to
measure default probability according to
assigned ration grades or categories.
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 Several reasons have contributed to the trend of
greater reliance on risk rating systems:
 A primary reason is that, as a measurement of asset
quality, credit rating systems have improved the precision
and effectiveness of managing credit risk exposure and
made the process more efficient and less time consuming.
 Secondly, they provide a conceptual credit risk framework
for transactions and facility structures by summarizing
risks and measurable outcomes of credit default loss.
 Third, as a portfolio monitoring tool, risk rating systems
can also be used to meet regulatory requirements such as
by monitoring exposure concentration limits, allocating
loan loss reserves, and managing capital requirements.
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 The basic theory of credit scoring is that
lenders and statisticians can identify the
financial, economic, and motivational factors
that separate good loans from bad loans
 Underlying assumption – the same factors
that separated good loans from bad loans in
the past will separate good loans from bad
ones in the future within an acceptable risk of
error
 Such an automated credit determining
system removes personal judgment from the
lending process
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Example: Credit Grading
▫ Most famous of all credit-scoring systems currently in use
▫ Scores range from 300 to 850 with higher values denoting
less credit risk to lenders
▫ The score are based on five different types of information
(most important to least important):
• The borrower’s payment history
• The amount of money owed
• The length of a prospective borrower’s credit history
• The nature of new credit being requested
• The types of credit that the borrower has already used

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 Credit rating used to support the credit
assessment and to determine the basis for
which the lender will evaluate borrowers.

 The most common types of credit ratings

that lenders use are internal and external
ratings, such as those provided by the public
rating agencies.

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 Lenders will also use external ratings for large
public companies to evaluate the credit
quality of a corporate borrower.
 Many lenders have developed their own
proprietary internal credit rating systems.
 Internal ratings are based on historical
customer information relative to the credit
relationship that a borrower has with the
financial service entity.
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External Rating
 Their ratings methodology has therefore
primarily been focused on long-term bond
issuers
 Moody’s
 Standard & Poor’s
 Fitch
 Credit ratings by public rating agencies,
alternatively, tend to be forward-looking in
evaluating the likelihood that a borrower will
default on long-term future obligations.

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Internal Rating
 Internal Rating at banks are based on
confidential information, some of which may
not be disposed for public availability.
 Banks need internal credit rating systems
that continuously provide updated
information to reflect a borrower’s financial
position, business or industry economic cycle
under the present circumstances.
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The main objective of conducting CRR are as
follows:
 It prioritizes our monitoring efforts on grade
“D” and “E” borrowers
 It serves to sieve out weak borrowers under
grades “D” and “E” where prompt phase
down or phase out remedial actions could be
taken if deemed necessary.
 It is a quick guide for approval of urgent
request.
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Credit Risk Rating (CRR) is based on the weighted
average scores of the borrower in four (4) main
areas, namely:
 Business trading record
 Conduct of facility
 Exposure to the Bank
 Financial health factors

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 CRR grading update is required during the
review of accounts. A complete of CRR score
sheet is to be attached with the completed
review form and submitted to Credit
Committee for noting and/or decisions.
 This is computed from the combination of
customer credit rating and security rating
 This rating evaluates the credit risk of the
customer
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 Credit rating systems have to be reviewed to
certify that the entire internal processes for
which they operate are uniform for ongoing
rating and monitoring functions.
 Credit rating systems need to establish a
benchmark performance against external
credit ratings.

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 Credit rating systems are at the heart of
credit risk management in that they provide a
road map to the entire credit process.
 Although most lenders prefer to use their
own internal proprietary rating systems.
 Credit rating systems must also be back
tested to validate their ongoing rating and
monitoring functions.

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