Credit Rating and Bank-Firm Relationships

New Models to Better Evaluate SMEs

Michele Modina

• Publisher: Palgrave Macmillan
• Year: 2015
• ISBN:
  9781137496225
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

This book explores the role of the rating system in creditworthiness assessment, looking into its current status, strengths and weaknesses and possible evolution in the light of Basel 3 and the Global Economic Crisis.

Part I

Credit Rating and Internal Rating Systems

1

Credit Rating

1.1 The distinctive features of credit rating

Rating systems are among the main innovations of the modern banking industry. Developed since the mid-1990s on the basis of a scheme that finds its definition in the working paper of the Basel Committee (BCBS, 1999), it is now possible to define more precisely the hallmarks of credit rating.

The rating is an innovative tool, widely spread, very important for the size of the investments made, the impact on the bank management and the bank-firm relationship. However, credit rating shows some weaknesses, the resolution of which requires the revision of some of its founding principles.

On the innovation front, the rating has introduced elements of strong innovation in the credit process contributing significantly to review the credit risk measurement both in large multipurpose banking groups and within commercial banks (Berger et al., 2005).

Before the introduction of the internal rating approach, the bank’s lending decisions were essentially binary. In fact, its role was limited to the granting or not of the loan based on the characteristics of the loan and on the borrower’s creditworthiness. The creditworthiness of a borrower was defined on the basis of knowing the applicant and on the guarantees made available to the borrower. The internal rating systems are, however, models that use quantitative techniques and measure the likelihood that the applicant becomes insolvent within a specified time horizon. The measure of the distance from insolvency becomes a guiding element that influences not only the granting of the loan, but also the general conditions of the loan and its pricing. In the decision-making process in credit granting, the statistical techniques of scoring have replaced the approach based on mutual sharing of the non-performing loans and on the unit costs of the credit production supporting instead the introduction of risk-adjusted pricing (Albareto et al., 2008). If until the 1990s the determinants of the rate charged by the bank were the delinquency rate of the banking system and the economic dimension of the borrower (the larger the company, the lower the loan production costs), nowadays there is a clear relationship between the counterparty’s risk defined by the rating and the rates charged to customers. To the company that has been assigned a better rating (worst), money is lent at lower interest rates (higher) and more (less) advantageous conditions.

In addition to being one of the major financial innovations, the rating process has reached a widespread diffusion which is the result of the intense activity carried out by the bank’s risk management division (De Laurentis and Maino, 2009). Having invested significantly in the development of internal rating methodologies and favoring their application in many countries, the idea that the validity of the credit rating system is not limited in time and its gradual expansion will be difficult to stop has been reinforced. Hence, the need to fully understand this tool in order to avoid adopting attitudes of uncritical acceptance. Understanding the rating methodology by identifying its potentials and also its limits is a commitment for all stakeholders (banks, businesses, academics) in order to make it as functional and usable as possible.

1.2 Literature review

The rating is an assessment of the overall solvency of the borrower, or the ability of a company to repay, at an agreed maturity, the principal and interest. In other words, it is a judgment on the borrower’s ability to generate the resources required to meet its commitments to creditors. The rating may also be referred to a single debt rather than the assessment of the overall solvency of the borrower. In essence, the rating indicates in a decisive, complete and unique manner the company’s degree of risk.

By assigning the rating, there is a measure of the borrower’s risk of failure to return the capital obtained with the loan because of its insolvency. The better the rating on the company, the lower the bank’s risk of losing their money and the lower should be, at least in theory, the interest rate they charge on the loan. The measurement of credit risk limits the information asymmetry by providing useful information to strengthen the process of decision making of those who grant funds. The adoption of the rating produces a major impact on the field of financial and credit intermediation since it reduces the manifestation of the phenomenon of adverse selection and moral hazard.

In recent decades, the literature on rating systems has extensively developed, ranging from construction methodologies to management uses and related organization.

A first conceptual framework of the philosophy of the rating system is found in the working paper of the Basel Committee (BCBS, 1999), which outlined a general scheme for the validation of the rating systems. This was followed by large and diverse literature, which investigated the issues in question from different points of view: the one regarding regulations, the one related to managerial implications and more specifically the economic-business one.

Among the works on the state of the rating systems in Italy the research by Albareto et al. (2008) and the survey of the Bank of Italy (2011) are worth mentioning. The latter, referred to the end of 2009, investigates 398 intermediaries (38 medium-large banks and 360 small ones and cooperative banks) on the subject of business assessment factors used by banks, the spread and the use of credit scoring models, and the effects of the crisis on business assessment factors. With reference to the first point, nearly 90 percent is (precisely 88 percent for medium-large banks and 87.9 percent for small ones and Italian Cooperative Credit Banks the share of intermediaries which include quantitative information that is not included in scoring models among the main elements when analyzing borrower’s creditworthiness (reference is made for example to the degree of use of credit lines or the frequency of overrunning). About half of the smaller banks in the sample (47.3 percent) and 32.5 percent of others give instead importance to qualitative information and to personal knowledge of the customer’s identity. However, the most striking differences between the two groups of banks regard the guarantees (considered important for 12.4 percent of the larger institutions compared to 32 percent of the smaller ones) and belonging to districts (considered only by 7.5 percent of the smaller banks and completely neglected by medium-large banks). The statistical-quantitative method contributes decisively when assessing customer risk for 63.1 percent of the major banks and for only 25.5 percent of the smaller ones. The tendency to intensify the development of credit scoring models by Italian banks, already highlighted by Albareto et al. (2008) for the period 2000–2006, is confirmed in 2009, and it can be attributed to the progressive use of new information technologies and telecommunication. Furthermore, while all banks tend to use credit scoring models for granting and monitoring credit, only for the bigger ones what can be noticed is an increase in the use of credit scoring models for the determination of pricing. Finally, irrespective of the size of the banks, the orientation of intermediaries is to strengthen the wealth of information on customers in conjunction with the financial crisis. As of October 2008, 21.4 percent of the larger banks and 53.9 percent of the smaller ones have increased the importance given to quantitative information not included in the automatic models; the percentages are respectively 49.5 and 73.2 percent if related to guarantees, as well as 37.8 and 35 percent if considering qualitative data. There is an increase, with the same intensity, for both types of banks, in the diffusion of exclusively statistical-quantitative methods (the variation is 26 percent for the larger banks and 24.8 for the others).

More generally, studies on rating systems that have taken place over time cover the following areas (Altieri Pignalosa et al., 2012):

•the mechanics of rating systems, i.e. the methods of construction of the variables/measures of credit risk and subsequent use in the process of credit risk management;

•the bank’s choices regarding the related organizational rating or better, the relationship between the rating philosophy, the size of the bank and the organizational choices;

•procyclicality of credit ratings and the evolution of the rating systems during the current financial crisis.

Belonging to the first, Sartori (2007) analyzes the estimation process EAD and its operational implications, while Oricchio (2007) works on the measurement of LGD, the cure rate and the capital ratios. Resti (2004) reports on the estimation of the EAD and of the Recovery Rate (RR). Berndt et al. (2005) dedicate their work to the estimate of the default risk premium, the default swap rate and their expected default frequency; Friedman and Sandow (2003) work on the estimation approaches of the RR. Vasicek (1987, 2002) estimates the probability of loss of a loan portfolio; Altman et al. (2002) investigate the interdependencies between RR and default rates and their potential effect on the procyclicality of capital ratio. Into this first thematic area is also included the work by Klugman et al. (2004) dedicated to the loss model and, in particular, to the operational process that separates the moment of data collection from the decision making process. De Laurentis and Maino (2009) analyze the basic elements of the profiles of credit risk, the main developments of international best practices in the area of credit risk management, as well as the technical and operational phases for the development of a rating system based on statistics.

As regards the relationship between rating philosophy and the size of the bank, the literature has extensively discussed reaching conclusions partially different especially with regard to the type of approach (relational or transactional banking) used by the bank.

The literature is unanimous in stressing that the adoption of credit scoring techniques is influenced both by the size of the intermediaries and by their organizational structure. Generally larger banks have more human, financial and technological resources to invest in technical innovation, also in the measurement of credit risk, and in the possibility of dividing the cost of investments on a larger loan portfolio. However, there are more noneconomic consequences related to the distance, as well as difficulties in the transmission of information not encoded within the structure, in the selection and monitoring of loans at a distance and in the formulation of proper incentives for local supervisors; the distance from the borrower can also reduce the weight of the soft information. Bongini et al. (2009) argue that large banks should also develop a relationship that focuses on customers and that it is achievable with different organizational and institutional models. From their point of view, there is no contradiction between big banks and maintenance / development of customer relationships, especially if banks adopt structures organized in market segments and pursue the personalization of the offer: in other words if they are organized as groups of intermediaries dedicated to specific territories. In a similar way, Berger and Udell (2002) argue that the larger banks, considered less capable of developing relations with smaller and riskier companies, must consider the market segmentation as a strategy to attack local credit markets better controlled by local banks.

When considering systems of delegation, recent evidence on a sample of 400 Italian intermediaries has shown that in the most acute period of the crisis, 2006–2009, the role of local managers in terms of decision making in granting loans to SMEs has weakened. Compared to the measurements of Albareto et al. (2008) for the period 2003–2006, in fact, the index of independent decision-making – in terms of the ratio between the amount of credit that the branch manager can grant to SMEs and the amount that can be granted by the Board of Directors – has decreased, especially for smaller banks.

In terms of related organization of the rating, other studies have pointed out that within the same organizational model can coexist different structural options (Schwizer, 2005), equally varied strategic guidelines and processes for rating assignment, configurations of the role of businesses management differentiated in terms of tasks and instrumentation (De Laurentis and Gandolfi, 2008).

However, the organizational structure of the ratings must function as the glue that keeps the mission to the strategic approach of the bank on individual segments of the credit market, since the options of the rating system are one of the most important components in the various segments of market, as noted by De Laurentis and Maino (2010).

The international financial crisis has highlighted some critical issues regarding the technical and methodological aspects of the rating systems, the related organizational profiles, as well as their managerial use, especially with reference to the impact on progressive selectivity of credit and, more generally, on the relationship between banks and companies. As already pointed out by Draghi (2009), if capital requirements depend on the rating, a possible recession will lead more frequently to higher default rates and a worsening of ratings, with the consequence of an increase of the minimum capital required by banks. Since it is more difficult to raise new equity during a period of recession, in order to maintain the ratio between capital and risk activities, banks end up granting less credit. This exposes companies to further financial stress, accentuating the recession. Similarly, the procyclicality effect of Basel II influences the performance of insolvencies and changes in the rating assigned to borrowers.

In recent years, the procyclicality of the rating system is one of the issues on which numerous empirical tests have focused their attention. Catarineu-Rabell et al. (2005), recognizing the greater procyclicality of Basel II through a theoretical model of general equilibrium, examine the implications of stable rating models in comparison to cyclical or countercyclical models. Saurina and Trucharte (2007) focus on the analysis of the cyclical nature of a mortgage portfolio built on data from the Spanish system. The stability of the capital requirement calculated under Basel II depends significantly on the estimating rating model Point Time or Through the Cycle. according to the concept Point in Time, the creditworthiness of the counterparty is measured in reference to the current solvency conditions; whereas with the concept Through the Cycle (typically adopted by the rating agencies), the borrower’s risk is evaluated over a much larger time horizon, typically measured over a full business cycle.

Recent studies have focused on the issue of rating during economic crisis. Salis and Turri (2009) showed that, in the current market turmoil, rating models that assume independence between the probability of default (PD) and Loss Given Default (LGD) appear no longer adequate in providing the actual riskiness of the borrower and of the lending process, thus leading to an underestimation of the capital required in macro-economic conditions and being adverse to accentuate the procyclical effects already inherent in the regulatory models. In addition, currently the methodology most widely used in LGD estimates – the actuarial analysis, which is based on discounting all cash flows recorded during the transition of the loan position to default to the closing of the practice – usually produces results which are not related to the actual situation of the economic cycle. This is especially true, as evidenced by Grippa et al. (2005), in contexts like the one in Italy where, due to its bureaucracy, it is characterized by very long recovery procedures.

De Laurentis and Maino (2010) point out that the current methodological approach of rating systems emphasizes the cyclical responsiveness of the rating; many, in fact, still use as a time-frame a one year period of observation from time zero, but this limits the temporal extension of validity and makes the evaluation of the customer relation more unstable over time and as a whole. The cyclical nature of the ratings can be measured with reference to the volatility of default by rating...

Table of contents

• Cover
• Title
• Introduction
• Part I  Credit Rating and Internal Rating Systems
• Part II  Toward a New Architecture of Rating
• Part III  Credit Rating in an Evolving Scenario
• References
• Index