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Rating Systems

Credit ratings are assessments of the credit standing of borrowers and guarantors. Credit ratings usually apply to large corporations, banks, insurance companies, sovereign or public sector entities. In retail banking, the large volume of statistics allows assessing the risk from statistical models or scores, which are addressed in the next chapter (Chapter 41). The major difference is that ratings include a judgmental component while scores result from a mechanical statistical fit of default events and observable variables.

Ratings rank the credit standing of debt issues using ordinal measures materialized by coded letter-grades for the ratings from agencies. Ranks are "ordinal numbers," not absolute values of the level of risk, by contrast with default probabilities which quantify the likelihood of default over a given horizon. Internal ratings refer to ratings assigned by banks to their borrowers. Unlike agency ratings, which use public scales, internal ratings use proprietary scales that vary across banks.

Credit ratings serve as the foundation for the "internal rating-based" approach of the New Accord and play a major role for differentiating credit risk of loans. Note that external ratings apply to debt issues, not of issuers. Ratings assigned to senior unsecured debt are close to issuer ratings since the debt defaults only if the issuer does. Basel 2 internal ratings should be issuer ratings.

Practices range along the entire spectrum of implementation of statistical models to "expert" judgment, with the intermediate solution blending some judgmental view with model outputs. Rating schemes use various criteria, from qualitative factors, such as strengths or weaknesses of firms, as well as the financiáis of corporate borrowers. The broad definitions are by credit rating agencies, even though the proprietary methodologies are much more detailed and structured. We provide in an appendix (Section 40.7) a sample of such broad descriptions of letter-grade credit ratings.

This chapter provides details about the philosophy underlying credit ratings and how they help in quantifying risks. Section 40.1 contrasts the philosophies of credit ratings for external rating agencies and for Basel 2 internal credit ratings from banks. Section 40.2 explains why the hierarchies of counterparties are of major importance for rating systems. Section 40.3 provides examples of common business rules for assigning credit ratings. Section 40.4 provides an overview of the main building blocks of internal credit ratings, which serve for making the rating system consistent and comprehensive. Section 40.5 provides sample rating grids for corporations and for banks. Section 40.6 explains how to move from internal ratings to default probabilities - one of the major credit risk components in risk models.

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