Definition: Credit rating

Credit rating generally refers to a procedure for assessing a debtor's creditworthiness using a rating scheme with various criteria. The rating result provides information about a debtor's probability of default and is essential for evaluating creditworthiness. The probability of default describes the likelihood of a payment default on the respective bond.

Rating procedures are used in different areas of finance. They can relate to assessing the creditworthiness of entire states, public bodies, organizations, or individual companies.

Internal and external credit rating

In banking, credit rating is widely used as an instrument to assess creditworthiness in corporate lending. Rating procedures also form the basis of the work of rating agencies, which classify the creditworthiness of debtors as independent institutions.

Well-known are mainly the major rating agencies Moody's, Standard & Poor's, Fitch and DBRS, whose assessments are influential for actors in the international financial markets. In addition, there are numerous smaller or specialized agencies that focus on certain segments, e.g., medium-sized companies, or specific industries.

Since there is no business relationship between a rating agency and the rated debtor, this is referred to as an "external" rating, as opposed to the "internal" rating of a credit institution within the scope of a creditworthiness assessment for a corporate client.

Methodologically, external and internal ratings are similarly designed. The following mainly focuses on credit rating in the sense of a bank-internal rating procedure.

Credit rating at banks under Basel II

Credit rating has long been used in banking as an instrument to assess creditworthiness. The focus is particularly on small and medium-sized enterprises as borrowers. In the course of the so-called Basel II process — the development of international capital standards for credit institutions — credit rating procedures have become significantly more important for banks.

While banks, before the entry into force of the Basel II regulations, generally had to back loans to companies with 8% equity, Basel II allows for risk differentiation in capital requirements. That means: loans to borrowers with high creditworthiness must be backed by a bank with less capital than loans to borrowers with lower creditworthiness.

The prerequisite is the qualified application of a recognized credit rating procedure by the bank, with which default risks can be measured in terms of probability and severity.

Since equity is a significant bottleneck for a credit institution, the risk classification of a borrower has considerable effects on bank calculations and credit terms. Borrowers with lower creditworthiness must expect risk premiums on loan interest rates or a negative credit decision based on the credit rating.

Under the Basel II agreement, two internal rating approaches (Internal Ratings Based = IRB) are recognized: the foundation IRB approach and the so-called advanced IRB approach. In both approaches, the bank must estimate the probabilities of default for borrowers individually based on a credit rating scheme. The two approaches mainly differ in the scope of eligible collateral considered and in determining defaults according to supervisory requirements or internal bank calculations.

Credit rating: Key elements

Credit rating in corporate lending typically includes the assessment of certain criteria, the so-called hard facts, soft facts, the industry, and possibly an individual factor. How detailed the credit rating is performed depends, among other things, on the size of the company and the scope of the credit engagement.

The design of credit rating varies from bank to bank. The following provides an overview of essential assessment areas.

The hard facts in credit rating

The hard facts focus on the assessment of a company's asset, financial and earnings situation. The basis is accounting data, primarily the balance sheet and profit and loss statement (P&L) or comparable documents if the business is not required to prepare formal financial statements. The analysis is typically carried out on the basis of appropriate ratios — for example, on capital structure, profitability and liquidity — and is mainly oriented toward historical data, often using a multi-period view. The analysis of accounting policy measures and account behavior also belongs here.

To take into account future developments, planning calculations and investment plans are included in the assessment. Because the evaluation of the hard facts is largely based on measurable numerical values, this is also referred to as a quantitative analysis.

The soft facts in credit rating

The soft facts are primarily about assessing the company's market position, competitiveness and future prospects. This includes, among other things, an evaluation of management regarding qualification, corporate governance, organization and strategic planning.

When assessing market position, the company's position is judged in comparison to its competitors (USP, competitive advantages and disadvantages) as well as in relation to its customers and suppliers. Information behavior and the customer-bank relationship can also be included in this assessment.

Since the classification of the soft facts is mainly based on hard-to-quantify judgments, this analysis is described as qualitative. Industry rating often plays a role in credit rating as well. This takes into account the risk situation and future prospects of the industry in which the company operates.

Industry rating is the only cross-company component in credit rating. It considers the fact that the development of the company under review normally correlates with industry development. Sometimes it is also possible, within the framework of an individual factor, to reflect credit-relevant peculiarities that are not captured by the normal credit rating scheme.

The rating result: impact and significance

The rating classifications for the individual assessment criteria are — if applicable weighted accordingly — combined into an overall rating classification (a rating result). As a minimum standard, a credit institution's rating system must have at least seven credit classes for non-defaulting and one rating class for defaulting loans under the Basel II requirements (seven-plus-one system). Many banks, however, use more finely differentiated systems. 20 to 25 rating classes are not unusual.

Each rating class is assigned a statement about the probability of default within one year (Probability to Default = PD) that on average applies to all credit exposures of that rating grade. In addition, the amount of a possible loss (Loss given Default = LGD) must be determined for a credit exposure. This largely depends on the extent to which a loan is covered by collateral.

In the ideal case the loan is fully secured, the LGD is zero; for unsecured loans it encompasses the entire loan volume. From the probability of default (PD) and the potential loss (LGD), the expected loss (Expected Loss = EL) of a credit exposure can be calculated using the following formula:

EL = PD x LGD

The EL indicates the customer-specific risk costs when granting a loan and is therefore an important calculation figure for the credit institution to determine loan terms. The unexpected loss results as the residual between the exposure at the time of default (Exposure at Default = EAD) and EL and is decisive for the required capital backing.

The application of credit rating procedures contributes to an objectification of creditworthiness assessments and thus also of credit decisions. They provide the bank with essential foundations for risk control of its lending business and for pricing oriented to risk costs.

Companies with good creditworthiness tend to benefit from the application of credit rating through more favorable loan terms and easier access to credit. The procedure places increased transparency requirements on every potential corporate borrower vis-à-vis the financing credit institution.