Credit Risk-Rating Systems.

In this first of two articles, the authors describe the capabilities, desired attributes, and potential accruing benefits of effective credit risk-rating systems. The practical issues arising in an overhaul, the main theme of the second article, will be shown through a case study of one regional bank's initiative to upgrade its credit risk management process.

Credit risk ratings provide a common language for describing credit risk exposure within an organization and, increasingly, with parties outside the organization. As such, they drive a wide range of credit processes--from origination to monitoring to securitization to workout--and it is logical that better credit risk ratings can lead to better credit risk management. Yet many lenders are using ratings systems that were put in place 10 or more years ago.

The primary barrier to change, it seems, is not that the old rating models cannot be improved but that the process of implementation is challenging. Ratings are so tightly woven into the fabric of most institutions that they are part of the culture. And any significant change to the culture is difficult.

However, the pressures to change are mounting from both internal and external sources. Internally, it may be the desire to price loans more aggressively or to support a more economically attractive CLO structure. Externally, the capital markets desire more detailed, more finely differentiated measures of credit portfolios. For corporate lending, credit scoring has been an important accelerator for securitizarion.

Justification for Change

A decade of advancements in quantitative measures of credit risk have led to better risk management at the transaction level as well as the portfolio level. Lenders can actively manage their portfolio risks and returns relative to the institution's risk appetite and performance targets.

At the same time, it is becoming increasingly clear that banks, in spite of their historical role, are actually disadvantaged holders of credit risk. The combination of high capital requirements and double taxation means that credit extension is typically not contributing positively to shareholder value creation. Improved risk ratings can improve the returns in this business by significantly lowering risk and process costs.

Some leading players are rethinking the business model as a credit conduit. The originate-and-hold strategy is being replaced with one of originate-package-distribute. Credit risk is becoming managed in much the same way as interest rate risk or equity risk. To make this strategy work, it is essential that credit risk is measured in a more standardized, accurate, and timely fashion.

Additional impetus is provided by the proposed reforms to bank regulation put forward by the Bank for International Settlements (commonly known as Basel II) that are intended to supersede the straight 8% minimum capital charge levied on banks since 1988. The expectations inherent in this reform adds to the pressures for changing internal risk rating systems. The promise is that less capital will be required for banks using more advanced ratings. Many banks will find that without a substantial overhaul, their credit risk-rating system will fail to meet Basel II guidelines.

Steps Toward Change Begin with Understanding the Goal

The fundamental goal of a credit risk rating system is to estimate the credit risk of a given transaction or portfolio of transactions/assets. The industry standard "building block" for quantifying credit risk is Expected Loss (EL), the mean loss that can be expected from holding the asset. This is …