INTERNAL RISK RATINGS

Credit Risk-Rating Systems

by Tom Yu, Tom Garside, and Jim Stoker

n 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 over-
haul, 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 man-
agement process.
redit risk ratings provide a models cannot be improved but portfolios. For corporate lending,
common language for that the process of implementation credit scoring has been an impor-
describing credit risk is challenging. Ratings are so tight- tant accelerator for securitization.
exposure within an organization ly woven into the fabric of most
and, increasingly, with parties out- institutions that they are part of the Justification for Change
side the organization. As such, they culture. And any significant change A decade of advancements in
drive a wide range of credit to the culture is difficult. quantitative measures of credit risk
processes—from origination to However, the pressures to have led to better risk management
monitoring to securitization to change are mounting from both at the transaction level as well as
workout—and it is logical that bet- internal and external sources. the portfolio level. Lenders can
ter credit risk ratings can lead to Internally, it may be the desire to actively manage their portfolio
better credit risk management. Yet price loans more aggressively or to risks and returns relative to the
many lenders are using ratings sys- support a more economically institution’s risk appetite and per-
tems that were put in place 10 or attractive CLO structure. formance targets.
more years ago. Externally, the capital markets At the same time, it is becom-
The primary barrier to change, desire more detailed, more finely ing increasingly clear that banks, in
it seems, is not that the old rating differentiated measures of credit spite of their historical role, are actu-
© 2001 by RMA. Yu is a senior manager specializing in North American work at Oliver, Wyman & Company (OWC) in New York;
Garside is director and head of the firm’s Risk Management Practice in London; and Stoker is a senior manager specializing in Risk,
based in New York. The authors acknowledge the assistance of George Morris, Jim Wiener, and John Stroughair, directors, and John
Stewart, senior manager, all at OWC. Oliver, Wyman & Company is a strategy consulting firm dedicated exclusively to the financial
services industry. Contact Stoker at [email protected]; visit OWC’s Web site at www.owc.com

38 The RMA Journal September 2001

 Effective Credit Risk
Rating Systems

ally disadvantaged holders of credit the mean loss that can be expected nation for credits that seem identi-
risk. The combination of high capital from holding the asset. This is cal- cal to the credit officer considering
requirements and double taxation culated as the product of three com- the loans, damages the credibility of
means that credit extension is typical- ponents: the model and makes it difficult to
ly not contributing positively to Expected Loss (EL) 5 employ as a decision-support tool.
shareholder value creation. Improved Probability of Default (PD) 3 Unconstrained model development
risk ratings can improve the returns Exposure At Default (EAD) 3 also runs the risk of creating a
Loss Given Default (LGD).
in this business by significantly low- black-box solution; to the extent
This article concentrates on the
ering risk and process costs. possible, a new rating system
success of a credit rating system in
Some leading players are (joined with good internal training)
rethinking the business model as a terms of its ability to quantify PD should produce results with which
and LGD. For most commercial
credit conduit. The originate-and- people are intuitively comfortable
exposures, EAD is generally treated
hold strategy is being replaced with and be capable of providing guid-
one of originate-package-distribute. independently from the risk ratings, ance on why discrepancies have
and this article will treat it as such.
Credit risk is becoming managed in arisen. At times, this will require a
The important risk drivers that
much the same way as interest rate high-level design decision regarding
risk or equity risk. To make this affect PD and LGD vary from asset the balance between complexity and
class to asset class. For example,
strategy work, it is essential that clarity within the institution. While
the drivers of risk vary widely
credit risk is measured in a more complexity can add to a model’s
standardized, accurate, and timely between retail, commercial, and predictive power, it can also reduce
asset-backed lending. Therefore, a
fashion. organizational buy-in by making the
successful credit risk rating system
Additional impetus is provided system less intuitive, dramatically
by the proposed reforms to bank reg- that covers material exposures reducing its practical value. Good
across a bank will necessarily be
ulation put forward by the Bank for rating systems should improve
quite complex, with numerous dis-
International Settlements (commonly process efficiency by reducing
known as Basel II) that are intended tinct models. process costs and freeing time for
This points to a second goal of
to supersede the straight 8% mini- sales and relationship management.
a credit risk rating system: It is not
mum capital charge levied on banks All of these points require trust in
since 1988. The expectations inher- enough to accurately measure risk, the rating system—users must be
it also must provide the bank with a
ent in this reform adds to the pres- confident that it works—with vali-
unified view of its credit risk. It
sures for changing internal risk rat- dation and back-testing as crucial
ing systems. The promise is that less needs to ensure that a rating system elements in achieving this.
permits the simple aggregation of
capital will be required for banks Designing a system to include
risk—by obligor, portfolio, line of
using more advanced ratings. Many all the qualities listed above is chal-
banks will find that without a sub- business, and product type—and lenging, because it involves both a
thus allow the institution to make
stantial overhaul, their credit risk-rat- technical excellence during the
decisions based on solid estimation
ing system will fail to meet Basel II development stage and potentially
guidelines. of the credit risk being taken. far-reaching organizational and cul-
Simply put, being “right” is not
tural realignments.
enough. The system must be easily
Steps Toward Change Begin with
Understanding the Goal understood by a wide range of peo- Components of a Successful
ple and be useful for management
The fundamental goal of a System
decision taking.
credit risk rating system is to esti- There are three key dimensions
mate the credit risk of a given trans- For the user, this means that it to a risk rating system, as seen in
should behave in an intuitive and
action or portfolio of transactions Figure 1. To be effective, a system
predictive fashion. For example, a
/assets. The industry standard must be successful in all three
“building block” for quantifying system that generates dramatically dimensions:
different risk ratings, without expla-
credit risk is Expected Loss (EL), 1. Ratings Scale addresses the

39
 Effective Credit Risk
Rating Systems

but often this

Figure 1
is not the case
with specific
credit expo-
sures being
overlooked,
such as letters
of credit or the
counterparty
credit risk aris-
ing from trad-
ing positions.
To get an accu-
rate profile of
an institution’s
credit risk
institution-wide metric against basis but poorly in gauging an
exposure, every credit exposure
which all assets will be com- absolute level of expected loss of
needs a comparable risk rating. The
pared. each.
key is to use a “master scale”—a
2. Ratings Assignment addresses Most rating systems use a two-
single scale to which all counterpar-
the actual ratings process. dimensional scale to solve this prob-
ties are mapped. It should be noted
3. Validation addresses confidence lem, with the probability of default
that having such a universal ratings
in the system, both internally (PD) and the loss given default
scale does not imply that all asset
and externally. (LGD) being quantified separately
classes use the entire scale. For
(consistent with the proposed Basel
Ratings scale. A risk rating example, you would expect corpo-
II guidelines). The first dimension
system uses an objective scale to rate loans to be concentrated at the
(PD) is primarily determined by the
rank credits according to risk. In top end of the scale (with low prob-
obligor characteristics. The second
defining the scale, we answer three ability of default) and retail loans to
dimension estimates how the facility
questions: be concentrated towards the lower-
structure affects the LGD.
• What does a given rating middle part of the scale.
A key element in the definition
mean? Ratings assignment. After the
of a ratings scale is the determina-
• How many ratings should there ratings scale is defined, it is neces-
tion of the appropriate level of gran-
be? sary to choose an approach for
ularity. Each grade should have
• To which credits does the scale assigning ratings to counterparties,
markedly (and measurably) different
apply? and this raises several issues:
risk characteristics. If the level of
The ultimate goal is to provide • How are ratings assigned for
granularity is too small (that is, there
a measure of the loss expected for each business unit?
are too few grades), the system will
booking a credit and the capital • Who assigns the ratings?
not be a useful decision support tool
required to support it. By examining • What tools are used in the
for management. Conversely, too
the ratings of any two credits in a assignment process?
much granularity may lead to a false
portfolio, we would like to know The answers to these questions
sense of accuracy (with models
which credit is riskier and the typically differ by business unit.
assumed better than they, in fact, are)
expected loss associated with each. Figure 2 classifies alternative
or too much detail as a basis for
Obviously, if we can answer the sec- ratings approaches—in practice;
management’s strategic decisions.
ond question, we know the answer to banks use a mixture of these,
Finally, an effective ratings
the first part. As mentioned, many depending on customer type. The
scale must be applicable across the
credit rating systems perform well in choice between methods should
bank’s entire credit portfolio. Banks
defining credit risk on a relative depend on their cost/benefit charac-
should strive to rate all exposures,

40 The RMA Journal September 2001

 Effective Credit Risk
Rating Systems

Figure 2

teristics. For example, the use of for achieving this will differ not The first two questions are
extensive financial and nonfinancial only from business line to business answered jointly, since validation
(subjective) data may result in line but also from bank to bank. At requires data. In fact, Basel II is
increased accuracy but can slow the some banks, ratings assignments for explicit about the need to validate
process, thereby adding cost. Such corporate and/or commercial credits internal ratings with historical data.
analyses should be used only when will be undertaken by the line, by Validation—the process of ensuring
the benefits from the marginal the credit function, or jointly. For that the ratings are accurately con-
increase in accuracy are great. This retail portfolios, it’s common for veying the bank’s credit risk—
applies to corporate lending, where centralized underwriting to assign includes:
many banks use a combination of ratings. The key is to ensure that it • Checking accuracy of rat-
financial and subjective information is clear who is responsible for ings—for example, are the
to drive a scoresheet approach to assigning the relevant ratings, be it model’s predicted results con-
assign ratings. In some cases, the line, credit, or centralized under- sistent with the default history
scoresheets may also be supple- writing, and that whoever assigns of the bank? If not, are the
mented by a model-based approach, the rating thoroughly understands models inappropriate, being
such as Moodys RiskCalc. the ratings approach. misused, or miscalibrated (both
Conversely, where the marginal ben- for PD and LGD)?
Validation. A key, but often
efit of increased accuracy at an indi- • Checking raters’ perform-
overlooked, part of a ratings system
vidual asset level is not as great— ance—for example, if there is a
is a well-defined process to ensure
for example, in small business lend- subjective component in the
that it is working well. Three ques-
ing —banks are making aggressive ratings process, does the rater’s
tions must be answered:
use of pure model approaches, simi- judgment improve the ratings
1. How are ratings validated?
lar to those used to manage retail or not?
2. What data is needed for valida-
credit card portfolios. • Checking applicability of mod-
tion and model refinement?
There should be a clear articu- els and tools—for example, has
3. Who is responsible for the
lation of responsibility for ratings enough data been collected for
analysis?
assignment. The best mechanism further refinements? Are there
41
 Effective Credit Risk
Rating Systems

newly available vended models Consistency

Figure 3
that outperform the current within a portfo-
Applications That Rely on Risk Ratings
one? lio. Two individ-
Without an effective process of ual raters inde- Process/Decision Credit Risk Rating System Role
validation, ratings will never pro- pendently evalu- Approval (new applications) Measure risk
vide confidence, either internally or ating a credit Test pricing adequacy
externally (and will not be accepted package should Syndications Pricing deal
by regulators for the purpose of cap- assign the same Increase market share in relation
to risk appetite
ital allocation). At a minimum, the rating (or very
required data for these analyses close), assuming Limit Setting Assist in determining capital cost
of increased concentration
should be explicitly specified and that both have
data-capture systems should be the same infor- Capital Management Loss forecasting and provisioning
Capital requirements
implemented to collect the data. It mation. Intra-
should be noted that all the data in portfolio ratings Risk Transfer Benefits of risk transfer depends
on estimate of risk
the world is worthless, unless some- inconsistency
one within the bank reviews and negatively affects RAROC Determine risk-adjusted profits
Economic capital estimates
analyzes it. Banks vary in their the efficiency of a function of risk
approaches, but the responsibility approvals and
Customer Profitability Estimate of customer-level
for data analysis must be clearly pricing and may Measurement risk-adjusted profit
specified. In some banks, this func- generate dis-
tion is delegated back to the busi- agreements
nesses, while in others it is central- between the line and credit func- Independent of regulatory pressure,
ized. tions. most banks have already been
increasing the granularity of their
What makes a risk rating Consistency across portfolios. risk-rating systems to meet compet-
system effective? Nearly all banks Credit risk should be discussed itive needs.
have risk rating systems, but not all across the entire organization in
common terms, facilitated by the Calibration. A risk rating sys-
systems perform well. A sound rat-
use of the central master scale, tem should be calibrated to the
ing system should improve a bank’s
described earlier. Inconsistency in bank’s own historical experience.
downstream tactical and strategic
the measurement of risk across Improper calibration leads to incor-
applications. Perversely, this is often
portfolios undermines most portfo- rect measures of credit risk and
an area of unexpected gain—ratings
lio-level decisions and processes potentially value-destroying deci-
are improved for regulatory reasons
and severely impairs the credibility sions being taken. It also under-
but are subsequently found to pay
and usefulness of bank-wide mines the system’s credibility, since
off in other areas. Banks miss sub-
RAROC / SVA systems. one should expect the line to notice
stantial opportunities if they view the
that the ratings are not providing
development of credit ratings prima- Granularity. To effectively dis- accurate information on the bank’s
rily as a regulatory compliance issue. tinguish between risk levels, ratings own experienced losses.
Robust credit rating systems have systems need a fairly high level of Calibration, like validation, requires
the potential for significant bottom- granularity, with increased granular- data and should be an ongoing
line impact and improved sharehold- ity in the portfolio subsegments process with regular refinement as
er value creation. Some examples of having a high concentration of cred- increased data becomes available.
value-adding applications are given it. Many first-generation rating tools
in Figure 3. with between five and 10 pass Speed and accuracy. Speed is a
An effective risk rating system grades are unsuitable for value- highly desirable goal but sometimes
should bolster these applications adding applications, such as risk- is obtained only at the cost of accu-
and processes. Those that do so adjusted pricing, portfolio manage- racy, particularly in judgmental sys-
exhibit certain features: ment, and securitization intiatives. tems. When specifically analyzed,
banks are often surprised by the

42 The RMA Journal September 2001

 Effective Credit Risk
Rating Systems

costs of origination, approval, and a reduction of loss volatility—and the bank expects greater losses or
monitoring. Faster processes are consequently economic capital con- there is most uncertainty.The same
favorable, since they reduce these sumption—by 20-30%. The pro- approach can be taken throughout
costs and improve the customer’s posed Basel II guidelines provide an the value chain—from approvals,
experience with banks. The key is additional regulatory carrot, whereby through monitoring, to recoveries—
to optimize the potental tradeoff banks with more advanced credit rat- but only if the risk inherent in each
between speed and accuracy. ing systems will also enjoy reduced credit is well measured. Banks that
regulatory capital requirements as have been aggressive in credit
Benefits of a Leading-edge applied to their lending activities. process redesign have seen large cost
Ratings System reductions in credit-related process-
Increased risk-adjusted prof-
Implementation of leading edge es. In many instances, banks have
itability. Generally, we expect
risk-rating systems can have sub- reduced credit-related expenses by
enhanced credit risk measurement to
stantial costs. Costs include devel- 25-30%.
boost risk-adjusted profitability by
opment staff (internal and external);
supporting improvements in pricing
software/ modeling costs; IT and Conclusion
discipline. Risk-adjusted pricing
infrastructure costs; and training Upon reviewing the Basel II
facilitates the cherry picking of
costs. Given these not inconsider- guidelines relating to internal credit
higher quality credits from banks
able costs, banks should expect sig- risk models, many credit risk man-
with less robust risk measurement
nificant benefits from ratings sys- agers at banks globally are faced
capabilities and also ensures ade-
tems implementation in addition to with the reality that their internal
quate compensation from riskier
regulatory compliance. Substantial risk-rating systems fall short of what
credits. It is possible to realize risk-
benefits can be achieved as applica- is necessary for compliance. What
adjusted improvements in profitabil-
tions leverage a leading-edge rat- options are available? What is the
ity of 10-15 bps of assets per year
ings system, including a reduction cost-benefit of each? The answers to
through these mechanisms. The net
in risk cost, increased risk-adjusted these questions are constrained by
present value of this benefit, assum-
profitability, and cost reduction available time, data, IT systems, and
ing a 15% discount rate, is 80-90
through credit process redesign. organizational needs. In the perfect
bps of assets minus the fixed costs
situation, highly customized ratings
Reduction in risk cost. Banks associated with the project.
systems with internally calibrated,
face two costs of credit risk: expect-
Cost reduction through quantitative models can be designed
ed losses and the cost of the capital
credit process redesign. Leading- and rolled out. This may be desir-
required to protect the bank against
edge risk rating systems allow banks able for the many banks that are
the volatility of losses. The direct
to reduce costs in many credit-relat- partway there already. For others,
benefit from the introduction of an
ed processes. The key benefit of rat- this may be impractical. Regardless
improved rating system is the reduc-
ings tools is that they allow the of the approach, all models need to
tion in credit losses due to improved
streamlining of the entire credit follow the same basic outline. The
asset selection and the avoidance of
process along risk-adjusted lines. benefits generated from putting in
“winner’s curse,” whereby a bank
Simply cutting costs across the board such a system can far outweigh the
that systematically misprices loans
may, in the long term, actually costs, even without considering the
suffers from negative selection. An
increase losses as appropriate con- regulatory advantages, and the value
indirect benefit from improved rating
trols are compromised. Instead, of such a system can only increase.
systems is the more efficient use of
efforts are reconcentrated on the p
economic capital through improved
areas where additional, costly assess-
portfolio composition. Active man-
ments have the greatest pay-back.
agement of the credit portfolio,
The approvals process, in relation to
underpinned by robust risk and valu-
low-risk transactions, can be semi-
ation metrics, can dramatically
automated while efforts are recon-
improve risk/return characteristics.
centrated on those deals for which
In many instances, it also can lead to
43