Govind Gurnani, Former AGM, Reserve Bank of India

Credit Rating Approaches In The Banks

Credit proposals of the borrowers are evaluated in the banks mainly

based on the bank’s internal rating and external credit rating of the
borrower issued by the external credit rating agency (ECRA). Credit
rating agencies provide information that nancial market participants
widely use for the management of credit risks. They form the external
source of credit ratings and are widely accepted all over the world.

External Credit Rating System

The ECRA rates the credit-worthiness of the corporates based on the

qualitative analysis of the company, assessments of the quality of
management and competitive aspects and a quantitative analysis of its
nancials such as ratio analysis.

The successive assignment of ratings move down the scale represents

an increase in risk. For instance, in the case of Moody’s ratings, ‘Baa
and above’ are said to be investment-grade while those below this level
are said to be non-investment-grade. In the case of S&P’s, ratings ‘BBB
and above’ are investment-grade. All the others are non-investment-
grade.

Apart from the assigning ratings, the ECRAs provide outlooks which
shows the changes likely to be experienced over the medium term.
▪ A positive outlook indicates that a rating is likely to be raised.
▪ A negative outlook indicates that a rating is likely to be lowered.
▪ A stable outlook shows that the rating is stationary.
▪ A developing outlook is an evolving one in which we can’t tell the
direction of the change.
▪ When a rating is placed on a watchlist, it shows that a very small
short-term change is expected.

Internal Credit Rating System

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 In order to build a sound internal rating system, the banks try to
replicate the methodology used by rating agency analysts. Such a
methodology consists of identifying the most meaningful nancial ratios
and risk factors. After that, these ratios and factors are assigned
weights such that the nal rating estimate is close to what a rating
agency analyst would come up with. Weights attached to nancial
ratios or risk factors are either de ned qualitatively following
consultations with an agency analyst, or extracted using statistical
techniques.

A rating structure can have three dimensions. Rating can be on the

basis of the characteristics of the borrower or on the basis of speci c
details of the transaction, or alternatively rating can be a summary
indication of risk that comprises both borrower and transaction
characteristics. The quality of credit decisions of a bank re ect in the
type of rating dimension it has adopted. If banks choose to rate both
borrower-wise and transaction-wise rating dimensions, a single
exposure receives two types of ratings under these two dimensions.
There are mainly two types of internal ratings used for evaluating the
credit proposals in the banks i) Point-in-time internal rating ii) Through-
the-cycle internal rating.

Point-in-time Internal Rating

Point-in-time internal rating evaluates the current situation of a

customer by taking into account both cyclical and permanent e ects.
As such, it is known to react promptly to changes in the customer’s
current nancial situation.

Point-in-time internal rating tries to assess the customer’s quantitative

nancial data such as balance sheet information, qualitative factors viz.
quality of management, and information about the state of the
economic cycle. Using statistical procedures such as scoring models,
all that information is transformed into rating categories. This rating is
only valid for the short-term or medium term, and that is largely
because it takes into account cyclic information. It is usually valid for a
period not exceeding one year.

Through-the-cycle Internal Rating

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Through-the-cycle (TTC) internal rating tries to evaluate the permanent
component of default risk. Unlike point-in-time rating, TTC rating is
said to be nearly independent of cyclical changes in the
creditworthiness of the borrower. TTC rating is not a ected by credit
cycles. As a result, it is less volatile than point-in-time rating and is
valid for a much longer period.

The advantage of TTC rating is that it is much more stable over time
compared to point-in-time rating. Because of its low volatility, TTC
rating helps nancial institutions to better manage customers. Too
many rating changes necessitate changes in the way a bank handles a
customer, including the products the bank is ready to o er.

The disadvantage of TTC rating over point-in-time rating is that it can

at times be too conservative if the stress scenarios used to develop the
rating are frequently materially di erent from the rm’s current
condition. If the rm’s current condition is worse than the stress
scenarios simulated, then the ratings may be too optimistic. In fact,
TTC rating has very low default prediction in the short-term.

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