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Credit Rating Models and Their Applications

Dr. Arindam Bandyopadhyay

National Institute of Bank Management

US Federal Reserve Chairman Mr. Alan Greenspan in April 2004 had made an interesting comment before the Senate Committee:
Only through steady and continued progress in measuring and understanding risk will our banking institutions remain vibrant, healthy and competitive in meeting the growing financial demands of the nation. Therefore, the regulatory authorities must provide the industry with proper incentives to invest in risk management systems that are necessary to compete successfully in an increasingly competitive and efficient global market.

Risk management is, first and foremost, a science. If you use accurate data, reliable financial models and the best analytical tools - you can minimize risk and make the odds work in your favour.

The Focus: Credit Risk


A bank always faces the risk that some of its borrowers may renege on their promises for timely repayments of loan, interest on loan or meet the other terms of contract. This risk is called credit risk. Credit risk is the risk that the borrower may be unable or unwilling to honour his obligations under the terms of contract for credit. A major part of the asset of a bank consists of loan portfolio. Banks suffer maximum loss due to non performing assets. The credit risk is thus a dominant concern on management of asset portfolio of any bank. credit risk varies from borrower to borrower depending on their credit quality. Basel II requires banks to accurately measure credit risk to hold sufficient capital to cover it.

Importance of Credit Risk Models


Credit risk models are intended to aid banks in quantifying, aggregating and managing risk across geographical and product lines. The outputs of these models also play increasingly important roles in banks risk management and performance measurement processes, customer profitability analysis, risk based pricing, active portfolio management and capital structure decisions.

Basel II has made a real contribution by motivating an enormous amount of effort on the part of banks (and regulators) to build (evaluate) credit risk models that involve scoring techniques, default and loss estimates, and portfolio approaches to credit risk problem.

What is Credit Risk?

Credit risk is risk resulting from uncertainty in a counterpartys ability or willingness to meet its contractual obligations. Credit risk is the probability of losses associated with changes in the credit quality or borrowers or counterparties. These losses could arise due to outright default by counterparties or deterioration in credit quality.

If credit can be defined as nothing but the expectation of a sum of money within some limited time, then credit risk is the chance that expectation will not be met.

Key Elements of Credit Risk


Factors affecting credit risk (expected and unexpected losses arising out of adverse credit events)
Exposure at Default (EAD) Probability of Default (PD) Loss Given Default (LGD) Default Correlations

Estimation of the average (mean expected) losses due to credit is commonly used to:
1) set reserve requirements for doubtful accounts; 2) establish minimum pricing levels at which new credit exposures to an obligor may be undertaken; 3) price credit risky instruments such as corporate bonds or credit default swaps; and 4) calculate risk adjusted performance measures such as RAROC.

Key Elements of Credit Risk


The bank can also suffer losses in excess of expected losses, say, during economic downturns. These losses are called unexpected losses. The capital base is required to absorb the unexpected losses, as and when they arise. Combining the results of models for default probabilities, recovery rates, and default correlation, a risk manager can estimate the expected and unexpected credit losses of an instrument and/or a portfolio, given knowledge of the exposure amount

Inputs of Individual Credit Risk


In assessing credit risk from a single counterparty, the Bank must consider the following inputs :

Exposure at Default (EAD): In the event of default, how large will be the outstanding obligations if the default takes place. EAD gives an estimate of the amount outstanding (drawn amount plus likely future drawdowns of yet undrawn lines) in case the borrower defaults. Probability of Default (PD): The probability that the obligator or counterparty will default on its contractual obligations to repay its debt. PD per rating grade is the average percentage of obligors that default in this rating grade in the course of one year. Loss Given Default (LGD): The percentage of exposure the bank might lose in case the borrower defaults. Usually it is taken as: 1-recovery rate Credit Migration: Short of a default, the extent to which the credit quality of the obligator or counterparty improves or deteriorates. Maturity: Time Horizon (Usually a time horizon of 1 year is considered).

1st Stage Output (at individual asset level)


Expected Loss for the ith advance (ELi) = PDi * LGDi * EADi Unexpected Loss (ULi) is the unanticipated loss in the risky asset due to the occurrence of default or unexpected credit migration ULi is defined as the standard deviation of the value of the asset ULi =EADi*LGDi*STDPDi =EADi*LGDi*SQRT {PD*(1-PD)} Assumptions Loss Given Default has no uncertainty Loss Given Default and Expected Default Probability are independent

Definition of Default/NPA
In the Indian parlance the defaulted loan is titled as Non Performing Asset (NPA). A loan is defined NPA on which

the interest or installment of principal has remained past


due for a specific period of time. The specific period of time for the year 1993 was four quarters, for 1994 three quarters, 1995 two quarters. Subsequently the RBI has implemented the 90 days

delinquency norm with effect from 31st March 2004


following the BIS norms.

Data Required for Credit Risk Estimation


The data required for credit risk estimation are essentially the ones used by the banks for appraisal of credit proposals. These include:
1) Detailed data on income and expenditure, assets and liabilities, cash flows of borrower, data on product structure, loss / claim history.
2) Market price of debt and equity instruments of quoted companies. 3) Credit ratings assigned by rating agencies 4) Credit derivative price data 5) Industry, market share data 6) Data on Management quality

The gathering of data for credit risk is a challenging task. IT system should be built in such a way that data on different aspects of operation of a loan flows into a central database that can be used for credit risk analysis.

The First Dimension of Basel II: Estimating Probability of Default


As the basic purpose of analysis of credit risk as part of
Basel II is to provide for adequate capital as a safety net against possible default, the first step is to develop a method of quantifying the chance of default. Thus, it is the frequency of default and the regularity with which it occurs that matters.

Approaches for Default Prediction


Credit Scoring Systems Expert judgement based Rating Models Structural Models/Option Theoretic Models/

Market based Models

Why Ratings Matter?


To ascertain financial health of individual obligor, facilities and portfolios and thereby assist in lending decisions. Ratings allow to measure credit risk , and to manage consistently a banks credit portfolio, i.e., to alter the banks exposure with respect to type of risk. Ratings are useful for pricing of a bond or a loan with respect to type of risk. Allocate reserve (covered by EL) and capital (covered by UL)

Credit Rating/Credit Score


An

opinion on the inherent credit quality of a company and or the credit instrument.

A Two-Tier Rating System Obligor Rating-indicates the chance of the borrower as a legal entity defaulting
Facility

Rating-indicates the loss of principal and/or interest on that facility; specific to the advance cum collateral

What is Credit Scoring?


Assigning a numeric formula to arrive at a summary number which aggregates all the risks of default related to a particular borrower. The final score is a relative indicator of a particular outcome (most often, creditworthiness or default probability of a borrower). However, as of now, credit-scoring models are not limited to predicting credit worthiness but also used in predicting potential bankruptcy.

External Rating Vs. Internal Rating


External ratings are generated by rating agencies (ECAIs). ECAIs specialize in the production of rating information about corporate or sovereign borrowers, they do not engage in the underwriting of these risks. The rating information is made public, while the rating process itself remains nondisclosed. Internal ratings, in contrast, are produced by Banks to evaluate the risks they take into their own books. It is not made public because of having competitive advantage.

Credit Scoring Systems


Credit Scoring systems use the Discriminant Methodology which determines which variables characterize good firms from bad What weight should be assigned to these variables to achieve the highest rate of predictive power The methodology is based on statistical distillation of the historical data The final score can be used to discriminate between good and bad credits Examples: Linear Probability Model, Logit Model, Probit Model, Discriminant Analysis Model (Altmans Z Score).

Statistical Approaches to Credit Scoring Models


Linear probability model: is based on linear regression, and uses a number of accounting variables to predict default probability. Logit model: assumes default probability is logistically distributed, and applies accounting variables as well as non-financial factors to predict default probability. Probit Model: is similar to logit model, except that the probit model arises from assuming that the probability distribution is normally distributed. Discriminant analysis model (e.g., Z-score): is based on finding a linear function of accounting and market based variables that best discriminates between firms that fail and those that do not.

Linear Probability Model


Regression model with binary dependent variable (=1 if default occurs and =0 otherwise)

Z
Example:

j 1

X ij error

Suppose there were two factors influencing the past default behavior of borrowers: the leverage or D/E and the sales/assets ratio (S/A). Based on past default (repayment) experience, the linear probability model is estimated as:

Z i 0.5 ( D / E )i 0.99 ( S / A)i


The major problem is that the estimated probabilities can lie outside the admissible range (0,1).

Logit /Probit Model


The Logit model solves the problem of the unbounded dependent variable by transforming the probabilities as follows: 1 F (Z i ) 1 e Zi The left hand side is the logistically transformed value of Z. The Probit Model is an extension of Logit which considers a cumulative normal distribution rather than a logistic function.

Both logit and probit models are very close and rarely lead to different qualitative conclusions, so that it is difficult to distinguish between them statistically.

MDA Analysis: Example Altmans Z Score Multiple Discriminant Altman, for the first time, applied
Analysis (MDA) in response to shortcomings of traditional
univariate financial ratio analysis. MDA models are developed in the following steps :
Establish a sample of two mutually exclusive groups: firms which
have failed and those which are still continuing to trade successfully Collect financial ratios for each of these companies belonging to both of these groups Identify financial ratios which best discriminate between groups (Ftest/ Wilks Lambda test). Establish a Z score based on these ratios.

Altmans Z-Score Model


Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5 Z = The Z score

X1 = Net Working Capital (NWC)/Total Asset (liquidity)


X2 = Retained Earnings/Total Asset (cumulative profitability) X3 = Profit before Interest and Tax (PBIT)/total assets (productivity) X4 = Market Value of Equity/Book value of Liabilities

(movement in the asset value)


X5 = Sales/Total Assets (sales generating ability)

Altmans Z-Score Model


It is a classificatory model for corporate customers
Zscore

> 2.99 - firm is in a good shape - warning signal trouble; firm could be heading towards

2.99>Zscore>1.81 1.81>Zscore-big

bankruptcy
Therefore,

the greater a firms distress potential, the lower its discriminant score

Z-score model can be used as a default probability predictor

model One of the most frequently asked question is How did he determine the coefficients or weights? Altman answers: The weights are objectively determined by the computer algorithm and not by the analyst. As such they will be different if the sample changes or if new variables are utilized.

Applying the Z-Score to Predict Default of an Indian Company


3.5 3.0 2.5 2.0 1.5 1.0 0.5 Bankrupted in yr. 2004 0.0 1990 1992 1994 1996 1998 Z 2000 2002 2004 Altman-Z Score for Arunoday Mills Ltd.

Expert Judgement Based Systems


The Risk Rating Methodology

Relies on experts insights into the borrowers financial health. Encompass financial, industry, business & management risk Projections and Sensitivity analysis Specify cut-off standards

Separate rating frameworks for large/mid corporates, small borrowers, retail loans, NBFCs etc.

Risk Assessment Tools for Large and Medium Businesses


Expert Judgement Based Models (Specific Inputs towards lending decisions)
Risk Categories

External

Internal

Industry Risk

Financial Risk

Business Risk

Management Risk

Facility Risk

Example: S&P, Moodys, Banks, NIBMs Credit Rating Model

Estimation of PD through Rating Transitions


PD can be estimated by analyzing Rating Transitions over time The methodology requires a rating wise cohort mortality rate analysis of the banks own internal rating data (say for 5 years), to find the number of firms in each rating class in each cohort moving towards default category (D) The year-wise PDs for different rating grades can be estimated by counting the number of defaulting companies in a yearly transition and dividing by the total number of firms at the beginning of the year. However, in order to obtain a through the cycle stressed PD, one has to take a weighted average of these marginal PDs over the entire sample period (i.e., average of 4 yearly cohorts)

The Transition Matrix


Transition Matrix: Probabilities of credit rating migrating from one rating quality to another, within one year
Table: 3 Average One Year Transition Matrix (Years 1995-96 to 2004-05) Year 2 Year 1 AAA AA A 97.08% 2.92% 0.00% AAA 2.54% 87.57% 7.93% AA 0.00% 4.35% 79.97% A 0.00% 0.74% 5.90% BBB 0.00% 0.83% 0.00% BB 0.00% 0.00% 0.00% B 0.00% 0.00% 0.00% C 0.00% 0.00% 0.31% D Source: CRISIL long term bond rating BBB 0.00% 1.05% 9.14% 67.53% 1.65% 7.41% 2.33% 0.31% BB 0.00% 0.60% 3.48% 14.76% 57.02% 0.00% 0.00% 0.92% B 0.00% 0.15% 0.44% 2.21% 4.13% 55.56% 0.00% 0.00% C 0.00% 0.00% 0.73% 3.69% 7.44% 7.41% 51.16% 0.00% D 0.00% 0.15% 1.89% 5.17% 28.93% 29.63% 46.51% 98.46%

When Do Firms Default?


In theory, corporate bankruptcy is driven by the fall in the asset value or by liquidity shortages (fall in the ability to raise capital to finance project). The market value of assets is a very powerful default predictor since it is an indicator of a firms economic prosperity or distress Moreover, some firms default at low asset values despite abundant liquidity. The market value of assets at default is on average 65 per cent of the face value of debt. It varies widely in the cross section, and depends on balance sheet liquidity, asset volatility and tangibility. Correct estimation of default probabilities is becoming an increasingly important element of banks measurement and management of credit exposures; inaccurate estimates of EDF could lead to a situation where too little capital is allocated to risky projects and as a consequence destroys shareholder value.

Option Theory Approach


Academic belief is that default is driven by market value of firms assets level of firms obligations (or liabilities) variability in future market value of assets As the market value of firms assets approaches book value

of liabilities, the default risk of firm increases


Default

Point: The threshold value of firms assets (somewhere between total liabilities & current liabilities) at which the firm defaults

Relevant Networth = Mkt. Value of Assets - Default Pt. Default: Relevant Networth = 0

Steps in Estimating EDFs

Estimation of asset value (current market value)


and volatility of asset return by solving two Black-Scholes.

Calculation of Distance to Default (DD) Mapping Expected Default Probability (EDF)

from DD

Vardhman Spinning & General Mills Ltd.: Market Net Worth


6.00

5.00

4.00

Rs. Billion

3.00

DP MVA

2.00

1.00

0.00 2000 2001 2002 Year 2003 2004

Data and Systems


Basel II demands the creation of historical

databases. For PD estimation gathering at least


five years of data is required. For loss given default (LGD) data and exposure at default (EAD) data based on internal credit loss experience, about seven years is required. All this data must be collated and a 12-month parallel run staged prior to implementation.

Why Internal Modeling and Validation is Important?


A bank needs to convince the bank supervisor why the estimates, PD, LGD and EAD are appropriate. Methodological soundness

Evidence on power of risk differentiation


Evidence on predictive accuracy Benchmarking with external data

Thank You

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