Advanced Credit Risk Analysis and Management

10

Credit Rating and Probability of Default

In this chapter, we will discuss how the individual obligor risks are assigned risk grades based on study. We will also discuss how the risk grades are linked to arrive at the probability of default and credit loss. In Chapter 8, we discussed the ‘Z-Score Model’ which predicts the likelihood of a firm going bankrupt. Z-Score is quite popular and can be considered as the basic form of credit rating. The main limitation of Z-Score is that it is based on pure financial numbers; however in practice the rating exercise is more elaborate and takes into account several non-financial factors as well.

10.1 CREDIT RISK GRADING

On completion of the credit evaluation process – the EIIF study – a rating grade/score would be assigned to the borrower. These grades depict the degree of credit risk associated with the borrower. Updating of the grades is often the fundamental basis of the continued loan/credit risk review process in banks and financial institutions. A sound rating system is essential to generate accurate and consistent risk ratings for risk monitoring and management.

A credit rating scale can comprise different levels. The Basel Accord has prescribed that at least seven risk grades are necessary. Some banks and FIs have more risk grades, as high as 23 in some cases. For example, if the scale comprises 8 levels, levels 1 to 5 would represent various grades of acceptable credit risk while levels 6 to 8 represent various grades of unacceptable ...