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The main purpose of credit rating is to evaluate the creditworthiness of corporate, municipal, and sovereign issuers of debt securities. In general, credit rating's job is to provide information to the investors about the possibility that they will receive all principal and interest payments scheduled for a given security (Caouette & Altman 2009, p. 65). On the other hand, it can be described as the “probability default”. According to (Business Dictionary 2009) mentioned that, “The probability default is a degree of certainty that a particular firm will go into default or a contractual party will not perform according to the contact.” In case, if the default is occurred, what level of recovery the investors can expect (Caouette & Altman 2009, p. 65). Credit rating is known as a summary indicator of the risk of loss from the failure of an obligor to complete a financial obligation (Ong 2003, p. 295). Traditionally, credit rating uses to describe the actions taken with respect to business borrowers, it also provides credit score for individual borrowers (Ong 2003, p. 295).
Basically, credit rating system analyses business by focusing in the three main areas, which are 1. Structure: (e.g. number of buyers and sellers, the degree of seller and buyer concentration, the extent and importance of regulation and conditions of entry, etc.) 2. Behaviour: (e.g. pricing, advertising, products, R&D, behaviour, influences, entry and regulatory) and 3. Performance: (e.g. profitability, efficiency, regulatory consequences) of the company (Levich & Majnoni 2002). After these three areas have been analyzed by the credit rating system, the system will predict and then measures of actual behaviour and performance of the company by gathering and comparing predictions with suitable analysis and discussion (Levich & Majnoni 2002). Consequently, the credit rating will explore some of these traditional aspects of the specific company. However, not all of the information and data will be available for every company, which will create a difficulty in terms of prediction and measurement to the credit rating system (Levich & Majnoni 2002). In recent times, the credit rating system becomes be very important in the management of credit risk.
There are mainly two types of credit rating, which are External credit rating and Internal credit rating. According to (Ong 2003, p. 295) stated that, “The term “credit rating” is general, applying to both public ratings by commercial firms that make money by creating ratings and internal ratings by financial intermediaries who use ratings as a tool in their other businesses (lending and derivatives activities).” Credit rating also uses to indicate score and mark for individual borrowers to evaluate their business performance.
2.2 External credit rating
External credit rating is known as public credit rating, which is produced by the credit rating agencies (Treacy and Carey 2000). The credit rating agency can be non - profit organisations, companies, cities or national government and the securities they issue can be traded on a secondary market (Straka & Alim 2009). A credit rating agency is a company that allocates credit ratings to institutions that issue debt obligations for example asset backed be receivables on loans, such as mortgage backed securities (Straka & Alim 2009). Each credit rating agency has different system of rating grades. There are two major credit rating agencies, which are Standard and Poor's (S&P) and Moody's. Every credit rating agency actually develops its own systems for sovereign and corporate borrowers for example Standard & Poor's and Moody's grading is slightly different (Straka & Alim 2009).
2.2.1 External credit rating (Moody's credit rating agency)
Moody's credit rating agency prinically provides ratings, research and risk analysis for a wide range of debt securities (Setty & Dodd 2003). The quantitative and qualitative factors are used by the Moody's credit rating agency to assess the company performance, trends as well as the probability default (Setty & Dodd 2003). Moody's credit rating agency tends to focus at the quantitative factors to evaluate historical performance and trends (Setty & Dodd 2003). Weight on each variable in Moody's credit rating is depending on factor such as status of the country whether the country is still in the middle of development period or whether the country has a very high come with long and stable history (Setty & Dodd 2003). For instance, balance of payment trends is a necessary element for developing countries at the same time as the fiscal policy is very important element for advanced countries (Setty & Dodd 2003). Along with the qualitative factors, the qualitative judgements are based on that data in the circumstance of the Sovereign's economic, political and social forces (Setty & Dodd 2003). Moody's credit rating agency has mentioned that the ratings are intended to serve as indicators or forecasts of the potential for credit loss due to failure to pay, partial payment and delay in payment (Treacy and Carey 2000). Moody's credit ratings concentrate on the Expected Loss (EL), which is a function of both Probability of Default (PD) and the expected Recovery Rate (RE). In consequence, (EL) = PD (1-RE) (Elkhoury 2008). Moody's credit rating agency concentrates on information that has been grouped into four categories, which are 1.Economic Structure and Performance, 2.Fiscal Indicators, 3.External Payment and Debt and 4.Monetary and Liquidity Factors (Setty & Dodd 2003).
Table: Moody's Sovereign Categories
1. Economic Structure and Performance
GDP, inflation, population, GNP per capita, unemployment, imports and exports
2. Fiscal Indicators
Government revenues, expenditures, balance, debt all as percentage of GDP
3. External Payment and Debt
Exchange rate, labour costs, current account, foreign currency debt and debt service ratio
4. Monetary and Liquidity Factors
Short-term interest rates, domestic credit, M2/foreign exchange reserves, maturing debt/foreign exchange reserves, liabilities of banks/assets of banks
Reference: (Setty & Dodd 2003)
Source: Setty, G. and Dodd, R. 2003, Financial Policy Forum: Credit Rating Agencies. Retrieved August 17, 2009 from http://www.financialpolicy.org/FPFSPR6.pdf
2.2.2 External credit rating (Standard and Poor's credit rating agency)
On the other hand, the Standard and Poor's credit rating agency seems to apply different theory and system compared to Moody's credit rating system. Referring to (Treacy and Carey 2000) stated that, “Standard and Poor's credit rating states that its rating are an “opinion of the general creditworthiness an obligor, or …of an obligor with respect to a particular …obligation …based on relevant risk factors.” Principally, Standard and Poor's credit rating is seeking to capture only the forward by looking for the probability of the occurrence (Elkhoury 2008). Standard and Poor's credit rating agency generally provides a wide range of information on financial products and markets, in addition, they also sell investment data, analysis, valuation as well as opinions (Setty & Dodd 2003). Fundamentally, Standard and Poor's credit rating agency evaluate credit worthiness from the information that has been grouped into 10 categories, which are included 1. Political risk, 2.Income and Economic Structure, 3.Economic Growth Prospects, 4.Fiscal Flexibility, 5.Government Debt Burden, 6.Off-Budget and Contingent Liabilities, 7.Monetary Stability, 8.External Liquidity, 9.Private Sector Debt Burdens and 10.Public Sector Debt Burdens (Setty & Dodd 2003).
Table: Standard & Poor's Sovereign Categories
1. Political risk
Stability, predictability and transparency of political institutions
Public and national security
Responsiveness to change and adapt
2. Income and Economic Structure
Degree economy is market - oriented
Extent of property rights
3. Economic Growth Prospects
Changes in standard of living
4. Fiscal Flexibility
Tax revenues, expenditures and past performance in balancing budgets
Methods of deficit financing and their inflationary impact
Growth friendly tax system and the ease of which it can be changed
Efficiency of expenditures
5. Government Debt Burden
Extent to which government can pay and manage its debt
6. Off-Budget and Contingent Liabilities
Size and health of non-financial public sector enterprises
Health of financial and banking system
7. Monetary Stability
Price behaviour in past economic cycles
Level, currency and maturity of public sector debt
Money and credit expansion
Independence of central bank
Compatibility of exchange rate regime with monetary policy
The range and efficiency of monetary policy tools
Depth and breadth of capital markets
8. External Liquidity
Structure of merchandise trade, service, income and transfers
Vulnerability to changes in investor sentiment
Gross external financing as a percentage of official foreign exchange reserves
9. Private Sector Debt Burdens
Residents assets and liabilities
10. Public Sector Debt Burdens
Trends in public sector debt
Foreign exchange reserves
Source: Setty, G. and Dodd, R. 2003, Financial Policy Forum: Credit Rating Agencies. Retrieved August 17, 2009 from http://www.financialpolicy.org/FPFSPR6.pdf
2.2.3 External credit rating in Thailand (TRIS)
In Year 1993, Thai government had an intention to enhance Thai economy, and expected that Thai economy will become the heart of Asian economy (TRIS 2009). Therefore, an idea of creating the organization that provides credit ratings for the investors was occurred. Thai ministry of finance supported the first public credit rating organization in Thailand, which is known as “TRIS” (TRIS 2009). TRIS is recognized as public rating agency in Thailand. Thai government expected that TRIS would facilitate the investor's decisions before they invest by providing information of the company to the investors such as finance, and business information (TRIS 2009). TRIS has been developed their credit rating system from the well-known credit rating agency in United States, which is called “Standard & Poor” (S&P) (TRIS 2009). After TRIS signed contract with Standard and Poor's credit rating agency in year 1993, Standard and Poor's credit rating agency have been facilitating and supporting TRIS to ensure that TRIS credit rating system is satisfied the international standard (Tris 2009). Bank A uses TRIS as its external credit rating system.
2.3 Relationship between External and Internal credit rating system
However, the external credit rating that each bank uses, it seems to influence the way they develop its own internal credit rating system. Referring to (Ong 2003, p. 299) informed that, “They found internal ratings were observationally similar to public ratings, in the sense that banks tended to use classification grades and frequently referred to agency rating letter grades in descriptions of their rating systems.” The internal credit rating system is normally comparing with the external credit rating system to ensure that all appropriate risk issues have been allocated in the internal credit rating system rather (Ong 2003, p. 299). The key aspects of operating design for internal credit rating include the role of external ratings and statistical model in the rating process, the organizational location of ultimate authority over grade assignments, the organizational division of responsibility for grading (line staff or credit staff), the nature of reviews of ratings to detect errors and the formality of the process and specificity of formal rating definitions (Treacy and Carey 2000). There is no specific model and rule that can identify how to weight all these attributes in the internal credit rating system (Ong 2003 p. 299). In fact, internal credit rating systems are not based on mathematical modelling but it based on general considerations and on experience (Ong 2003 p. 299). Nonetheless, internal credit rating system still relies on the judgement of external rating evaluators (Ong 2003, p. 299).
The external credit rating seems to be involved by a large number of parties for different purposes to ensure that the external credit rating will be useful in wide area (Treacy and Carey 2000). In contrast, the internal credit rating usually focuses the important aspects only on the marking criteria, for example, bank uses internal credit rating to determine regulatory capital adequacy and bank can concentrate on the risk return profile in commercial lending (Treacy and Carey 2000). Furthermore, the external credit rating also provides the distinction of risk on the rating scales, which is included forms and meanings that are stable over time. The investment grades for sovereign and corporate borrowers between Moody's credit rating and Standard and Poor's credit rating is also different (Straka & Alim 2009). (See appendix chapter 2: 1) Sometimes, Moody's credit rating agency claims that their ratings embed a conceptual superior approach that directly considers not only the likelihood of default other than that also the severity of loss in the event of default (Straka & Alim 2009).
2.4 Internal credit rating
The external credit rating agencies provide information that has purpose to help the investors to classify the borrowers by their relative riskiness (Ong 2003, p. 296). However, there are mainly two reasons for the bank to do develop its own internal credit rating of obligor creditworthiness. First, sometimes bank has to deal with the customers that do not issue publicly rated debt. Second, bank may want to use the credit rating in a different way compared to the users of external credit rating (Ong 2003, p. 369). Each bank regularly kept their internal credit rating system privately as well as the costs and benefits of their internal credit ratings for example consistency, pressures for accuracy (Treacy and Carey 2000). Moreover, well distinction of risk are is necessary for internal credit rating, because it will influence a function for the ways in which ratings are used in managing and maintaining their the portfolio (Treacy and Carey 2000). The internal credit rating system analyses should discover the financial health of the firm, and evaluate the earnings and cashflows whether the company can cover the debt obligation or not (Ong 2003, p. 369). The internal credit rating analysis is more likely to concentrate on the area such the quality of assets of the firm as well as the liquidity position of firm (Ong 2003, p. 370). Nevertheless, the analysis should be able to determine the unfavourable aspects of the borrower's management as much as possible before evaluating credit score for them (Ong 2003, p. 370).
At every large bank around the world, internal credit rating appears to be very important to them as an element of credit risk management. The main purpose of the internal credit rating is to summarise the risk of loss due to the failure by a given borrower to pay as promised (Treacy and Carey 2000). Fundamentally, Bank uses internal credit ratings in two types of activity, which are analysis & reporting, and administration (Treacy and Carey 2000). For example, administrative uses internal credit rating for guiding loan origination, loan monitoring process and regulatory compliance (Treacy and Carey 2000). On the other hand, analytic uses consist of reporting of risk postures to senior management and broads of directors use such as profitability measure, loan loss reserving, economic capital allocation, product pricing and (indirectly) employee compensation (Treacy and Carey 2000).
2.4.1 The characteristics of internal credit rating system
The internal credit rating system is usually based on both quantitative and qualitative evaluation (Ong 2003, p. 369). It normally analyses in three areas, which are 1. Financial analysis, 2. Industry analysis, and 3. Business analysis (Treacy and Carey 2000). Each analysis focuses on different factors, which is related to the company directly but in the different way (Treacy and Carey 2000).
22.214.171.124 Financial Analysis:
The purpose of the financial analysis is to determine the borrower's debt service capacity is essential, although, there are various types of information that need to be considered with the borrower's characteristics such as cash flow, interest coverage, leverage and other characteristics are usually evaluated to the standard of the borrower's industry (Treacy and Carey 2000).
126.96.36.199 Industry Analysis:
The Industry analysis is also a very important analysis in the internal credit rating system because industry analysis can influence ratings in that market, the leaders of the market usually consider to be the less risky due to high experience resulted in less competitive pressure, conversely, for the firms that operate their business in the declining industries are judged to be more risky (Treacy and Carey 2000). The features of the industry analysis is included the potential client belongs, also the status of the company in the industry (Ong 2003, p. 378).
188.8.131.52 Business Analysis:
The country risk factor and the effects from of macro-economic event in particular country is very crucial, so it should be considered in the Business analysis part (Ong 2003, p. 378). If the financial and industry factors of the company are favourable, then bank needs to consider the size of company because size of the company can affect their ratings grades (Treacy and Carey 2000). The size of the firm may have an impact on their credit rating score. Normally, the medium size and smaller seems to be assigned with relatively risky grades by the bank, because medium and small firms have a limited access to the external finance compared to the large firms. In terms of assets, medium and small firms normally don't have a large amount of assets that can be sold during the crisis period without disturbing the operations (Treacy and Carey 2000). The other risk factors concentrate on the reliability of the borrower's financial statements as well as the quality of its management (Treacy and Carey 2000). The elements of transaction such as collateral or guarantees will be taken into account for consideration too, since it's related to the possibility and potential of how the company will repay the loan (Treacy and Carey 2000).
2.5 The Implementation of internal credit rating system around the world
Recently, the businesses have become extensively more diverse and complicated as well as the number of counterparties has increased quickly which will create a limit the traditional methods or controlling and managing the risk. Therefore, each bank has its own internal credit rating system for example the number of grade and the risk associated with each grade is diverge. For the reason that the each bank has developed its own internal credit rating is because each bank is operating in different line of business or they may use internal credit rating for different purpose which will influence the way they design and operate their own internal credit rating system in order to meet their needs (Treacy and Carey 2000). Mostly, bank tends to use their internal credit rating to identify the loans problems, and to ensure that proper monitoring may discover that a rating scale with relatively few grades is adequate. Furthermore, bank also uses their internal credit ratings in calculating the profitability for different types of loans. However, to achieve fine distinction of credit risk, bank may require scale with various grades in order to rate each company accurately.
At the beginning before each bank develop its own internal credit rating system, they should consider which loss concepts to apply as well as the meaning of grades on the rating scale that is compatible with the loss concept, additionally, the bank may also include “watch” and “regulatory” grades on such scales (Treacy and Carey 2000). There are many factors that need to be considered before bank develops its own internal credit rating system such as internal and external factors. Nevertheless, the choices that have been made by the bank usually come along with many reasons, but the primary determinant of bank internal credit rating system architecture appears to be the mixture of large and smaller borrowers which will relate to the level of how the bank uses quantitative system in order to manage their credit risk and profitability analysis (Treacy and Carey 2000). Moreover, it depends on who assigns the ratings for each company as well as the method of reviewing the rating assignments.
2.6 Internal credit ratings consistency across banks
Since, internal credit rating system architectures and operations differ greatly across banks, due to the fact that each bank is facing different circumstances as well as the differences in their business line. However, the main concern for applying degree of internal credit ratings consistency across bank is mainly related to reducing risk (Ong 2003, p. 307). For example, frequent error in internal credit ratings can decrease lender's earnings by decreasing the quality and efficiency of its borrower monitoring processes (Ong 2003, p. 307). At this time, such validation appears to be quite complicated to the investors because each bank's rating scale is dissimilar, additionally, loss concepts are ambiguous and the rating criteria are largely embedded in bank culture rather than written down (Treacy and Carey 2000). Therefore, in chapter 4 (Main findings & discussion), this dissertation will discuss how effective is the internal credit rating system in Thailand.
Chapter 2 references
Business Dictionary 2009, Default probability. Retrieved August 15, 2009 from http://www.businessdictionary.com/definition/default-probability.html
Caouette, J.B., Altman, E.I. and Narayanan, P. 1998, Managing Credit Risk: The next great financial challenge, Canada, John Wiley.
Treacy, W.F., and Carey, M. 2000, Credit risk rating systems at large US banks. Retrieved August 15, 2009 from Journal of Banking and Finance database.
Levich, R.M., Majnoni, G. and Reinhart C. 2002, Ratings, Rating Agencies and The Global Financial System, United States of America, Kluwer Academic Publishers.
Straka, T., Alim, W. and Hughes T. 2009, Credit Rating Agencies. Retrieved August 17, 2009 from http://www.wikinvest.com/concept/Credit_Rating_Agencies
Elkhoury, M. 2008, Credit Rating Agencies And their Potential Impact on Developing Countries. Retrieved August 14, 2009 from http://www.unctad.org/en/docs/osgdp20081_en.pdf
Setty, G. and Dodd, R. 2003, Financial Policy Forum: Credit Rating Agencies. Retrieved August 17, 2009 from http://www.financialpolicy.org/FPFSPR6.pdf
Ong, M.K., 2003, Credit Ratings: Methodologies, Rationale and Default Risk, Risk Waters Group.
Tris 2009, Company Information. Retrieved August 18, 2009 from http://www.tris.co.th/
Chapter 2 appendices
Standard & Poor's use a system of letter sliding from the best rating “AAA” to “D” for issuers already defaulting on payments
o AAA: best quality borrowers, reliable and stable without a foreseeable risk of future payments of interest and principal
o AA: very strong borrowers; a bit higher risk than AAA
o A: upper medium grade; economic situation can affect finance
o BBB: medium grade borrowers, which are satisfactory moment
o BB: lower medium grade borrowers, more prone to changes in the economy, somewhat speculative
o B: low grade, financial situation varies noticeably, speculative
o CCC: poor quality, currently vulnerable and may default
o CC: highly vulnerable, most speculative bonds
o C: highly vulnerable, perhaps in bankruptcy or in arrears but still continuing to pay out an obligations
o CI: past due on interest
o R: has selectively defaulted on some obligations
o D: has default on obligations and S&P believes that it will generally default on most or all obligations
o NR: not rated
(Reference: Straka and Alim 2009) Moody's grading follows a different system
o Aaa: Obligations rated Aaa are judged to be of the highest quality, with the “smallest degree of risk”
o Aa1, Aa2, Aa3: Obligations rated As are judged to be of high quality and are subject to very low credit risk, but “the susceptibility to long-term risks appears somewhat greater”.
o A1, A2, A3: Obligations rated A are considered upper-medium grade and are subject to low credit risk, but that have elements “present that suggest a susceptibility to impairment over the long term”.
o Baa1, Baa2 Baa3: Obligations rated Baa are subject to moderate credit risk. They are considered medium-grade: as such “protective may be lacking or may be characteristically unreliable”.
o Ba1, Ba2, Ba3: Obligations rated Ba are judged to have “questionable credit quality”.
o B1, B2, B3: Obligations rated B are considered speculative and are subject to high credit risk, and have “generally poor credit quality”.
o Caa1, Caa2, Caa3: Obligations rated Caa are judged to be of poor standing and are subject to very high credit risk and have “extremely poor credit quality. Such banks may be in default…”
o Ca: Obligations rate Ca are highly speculative and are “usually in default on their deposit obligations”.
o C: Obligations rated C are the lowest rated class of bonds and are typically in default, and “potential recovery value are low”.
o WR: Withdrawn Rating
o NR: Not Rated
o P: Provisional
(See appendix chapter 2: 1)
(Reference: Straka and Alim 2009)