The existence of credit ratings is widely known. They often appear in several newspapers, and magazines. Nevertheless, various mid-market companies cannot estimate the impact and importance of credit ratings. Specifically, differences between internal credit and external ratings are often unclear. This study compares internal and external credit ratings in order to see their importance, and why they provide the opportunity to improve the individual financial situation of mid-market companies. Even further, this study shows the relevant differences and similarities of internal and external credit ratings, and explains, why external credit ratings can help German mid-market companies in financing process. Financing is a fundamental factor in the success of a company. Without sufficient liquidity a company cannot invest, and without investments a company cannot grow. German mid-market companies need to ensure their financing in order to have sustainable success.
Internal Credit Rating
Under the Basel II guidelines, banks are allowed to use their own estimated risk parameters for the purpose of calculating regulatory capital. This is known as the internal ratings-based (IRB) approach to capital requirements for credit risk. Only banks meeting certain minimum conditions, disclosure requirements and approval from their national supervisor are allowed to use this approach in estimating capital for various exposures.
Risks of Default
The advanced internal rating-based models help determine the risks of default in a variety of fields, including:
- Loss Given Default (LGD)
- Exposure at Default (EAD)
- Probability of Default (PD)
The three fields mentioned above help determine the risk-weighted asset (RWA) that is calculated on a percentage basis for the total required capital. They help make a structural model of credit risk that can assist in formulating internal rating-based approaches for credit risk management within a bank. The model aids in avoiding pitfalls and unnecessary stresses on a bank’s balance sheet that can end up threatening the liquidity or long-term profitability of the financial institution as a whole.
The ratings-based approaches help maintain controls within the various departments of the banks to ensure that they do not over-leverage in any specific way.
Basel II Rule Requirement
The AIRB systems were proposed under the Basel II capital adequacy rules. Basel II is a set of recommendations for financial institutions globally that help form banking laws and financial best practices.
An external rating scale is a scale used as an ordinal measure of risk. The highest grade on the scale represents the least risky investments, but as we move down the scale, the amount of risk gradually increases (safety decreases).
An issue-specific credit rating conveys information about a specific instrument, such as a zero-coupon bond issued by a corporate entity. An issuer-specific credit rating, on the other hand, conveys information about the entity behind an issue. The latter usually incorporates a lot more information about the issuer.