External Credit Ratings
External rating scales are designed to convey information about either a specific instrument, called an issue-specific credit rating, or information about the entity that issued the instrument, which is called an issuer credit rating, or both.
The usual steps in the external ratings process include qualitative and quantitative analysis, a meeting with the firm’s management, a meeting of the committee in the rating agency assigned to rating the firm, notification of the firm being rated of the assigned rating, an opportunity for the firm to appeal the rating, and an announcement of the rating to the public.
The probability of default given any rating at the beginning of a cycle increases with the horizon.
Although external ratings have had a fairly good record in indicating relative rates of default, they are designed to be relatively stable over the business cycle (i.e., using an average cycle approach), which can produce errors in severe cycles.
Interpreting external ratings may vary based on the industry but not necessarily on the geographic location of the firm. Ratings delivered by more specialized and regional agencies tend to be less homogeneous than those delivered by major players like S&P and Moody’s.
Generally for bonds, a ratings downgrade is likely to make the price decrease, and an upgrade is likely to make the price increase. For stocks, a ratings downgrade is likely to lead to a stock price decrease, and an upgrade is somewhat likely to lead to a price increase.
Internal Credit Ratings
Since external credit ratings models have been thoroughly tested and validated, it makes sense for banks to apply these techniques when developing internal credit ratings to assess the creditworthiness of their own borrowers.
In order to build an internal rating system, banks should create ratings that resemble those set by ratings agencies. However, before banks can link default probabilities to internal ratings, it is necessary to back-test the current internal rating system.
Through-The-Cycle And At-The-Point
The internal at-the-point ratings approach to score a company is usually short term, uses quantitative models like logit models, and produces scores that tend to vary over the economic cycle.
The internal through-the-cycle ratings approach to score a company has a longer horizon, uses more qualitative information, and tends to be more stable through the economic cycle.
Internal ratings can have a procyclical effect on the economy since banks often change ratings with a lag with respect to the change in the economy. Thus, after the economic trough has been reached, it is possible that a bank may downgrade a company poised for recovery with the use of additional credit from the bank.
Ratings Transition Matrix
Transition matrices show the frequency of default, as a percentage, over given time horizons for bonds that began the time horizon with a given rating. These tables demonstrate that the higher the credit rating, the lower the default frequency.
The Biases That May Affect a Rating System
An internal rating system may be biased by several factors, including time horizon bias, information bias, criteria bias, and back-testing bias.
