Risk rating models are tools used to assess the probability of default. The concept of a risk rating model is deeply interconnected with the concept of default risk and a key tool in areas such as risk management, underwriting, capital allocation, and portfolio management.
A risk rating model is a key tool for lending decisions and portfolio management/portfolio construction. They give creditors, analysts, and portfolio managers a rather objective way of ranking borrowers or specific securities based on their creditworthiness and default risk.
They also allow a bank to set and monitor the level of risk in their credit portfolio and assess whether specific adjustments are needed.
Other factors may involve a subjective assessment of a company’s competitive strengths, management’s reliability, political risks, and environmental risks. For these factors, it’s often necessary to use discretion when ranking the related risks, as it’s difficult, if not impossible, to quantify or rank them in an objective way.
- Judgment vs. Data
The methodology used to develop the risk rating model can give more weight to judgment or statistics. It will depend on the availability of relevant data, the integrity and accuracy of the data, and the ease of storage and access to such data.
- Borrower’s Financial Health
The factors that assess a borrower’s financial health generally include a variety of ratios:
- Liquidity, to determine whether a borrower is able to pay off their current obligations. Such ratios include the cash ratio, the current ratio, and the acid ratio.
- Leverage ratios, also called solvency ratios, to assess a company’s ability to meet its long-term financial obligations. These ratios look at a company’s capital structure and include the equity ratio or the debt ratio.
- Profitability ratios, to determine whether the company generates profits in its ordinary business activities. Such ratios include the operating margin, the EBITDA margin, and the return on invested capital, to name a few.
- Cash flow ratios, which compare cash flow metrics to other financial KPIs or leverage indicators, to assess a company’s ability to generate cash flows that can be used to pay off its obligations. For example, such ratios include the cash flow coverage ratio or the cash flow to net income ratio.
- Industry Characteristics
A borrower’s ability to pay off their obligations may not just depend on company-specific factors. Industry characteristics and macroeconomic factors can affect a company’s creditworthiness. For example:
- In an industry with low barriers to entry, a company’s ability to generate cash flows may be less predictable or subject to more significant risks.
- In a cyclical or commoditized industry, a company’s cash-flow generation may be significantly more volatile than in a defensive industry or natural monopoly.
- For any industry, the current phase of the industry or business cycle can affect a company’s creditworthiness. For example, in the recession phase of the macroeconomic cycle or in the decline phase of the industry cycle, even companies that are financially healthy may face a deterioration in creditworthiness.
- Management’s Quality and Reliability
Many risk rating models give a score to a company’s management based on a combination of objective and subjective factors:
- Assessment of the management’s tenure and experience, which comprise rather objective elements, such as the management’s seniority and years of experience, and more subjective ones, such as the relevance of the experience and qualifications.
- A deeper analysis of a management’s history of value creation, clarity of communication, quality and frequency of information disclosed, and capital allocation decisions.
- Political and Environmental Risks
Risk rating models also use additional categories of risk factors:
- Political risks, which consider aspects such as the risks of war, the rule of law, and the reliability of the institutions, to name a few.
- Environmental risks related to the potential consequences of pollution or destruction of the natural environment due to the company’s activity. It can cause financial consequences and even adverse regulations that can limit or disrupt a company’s operations.
Methodology of Credit Rating
The process of credit rating begins with the prospective issuer approaching the rating agency for evaluation. The experts in analyzing banks should be given a free hand and they will collect data and informant and will investigate the business strength and weaknesses in detail. The entire process of rating stands of confidentiality and hence even the most confidential business strategies, marketing plans, future outlook etc., are revealed to the steam of analysis.
The rating is based on the investigation analysis, study and interpretation of various factors. The world of investment is exposed to the continuous onslaught of political, economic, social and other forces which does not permit any one to understand sufficiently certainty. Hence a logical approach to systematic evaluation is compulsory and within the framework of certain common features the agencies employ different methodologies. The key factors generally considered are listed below:
- Business Analysis or Company Analysis
This includes an analysis of industry risk, market position of the company, operating efficiency of the company and legal position of the company.
- Industry risk: Nature and basis of competition, key success factors; demand supply position; structure of industry; government policies, etc.
- Market position of the company within the industry: Market share; competitive advantages, selling and distribution arrangements; product and customer diversity etc.
- Operating efficiency of the company: Locational advantages; labour relationships; cost structure and manufacturing as compared to those of competition.
- Legal Position: Terms of prospectus; trustees and then responsibilities; system for timely payment and for protection against forgery/fraud, etc.
- Economic Analysis
In order to evaluate an instrument an analyst must spend a considerable time in investigating the various economic activities and also analyze the characteristics peculiar to the industry, whose issue the analyst is concerned with. It will be an error to ignore these factors as the individual companies are always exposed to changing environment and the economic activates affect corporate profits, attitudes and expectation of investors and the price of the instrument. hence the relevance of the economic variables such as growth rate, national income and expenditure cannot be ignored. The analysis, while doing the economic forecasting use surveys, various economic indicators and indices.
- Financial Analysis
This includes an analysis of accounting, quality, earnings, protection adequacy of cash flows and financial flexibility.
- Accounting Quality: Overstatement/under statement of profits; auditors’ qualification; methods of income recognition’s inventory valuation and depreciation policies, off balance sheet liabilities etc.
- Earnings Protection: Sources of future earnings growth; profitability ratios; earnings in relation to fixed income changes.
- Adequacy of cash flows: In relation to dept and fixed and working capital needs; variability of future cash flows; capital spending flexibility working capital management etc.
- Financial Flexibility: Alternative financing plans in ties of stress; ability to raise funds asset redeployment.
- Management Evaluation
- Track record of the management planning and control system, depth of managerial talent, succession plans.
- Evaluation of capacity to overcome adverse situations
- Goals, philosophy and strategies.
- Geographical Analysis
- Location advantages and disadvantages
- Backward area benefit to the company/division/unit
- Fundamental Analysis
Fundamental analysis is essential for the assessment of finance companies. This includes an analysis of liquidity management, profitability and financial position and interest and tax sensitivity of the company.
- Liquidity Management: Capital structure; term matching of assets and liabilities policy and liquid assets in relation to financing commitments and maturing deposits.
- Asset Quality: Quality of the company’s credit-risk management; system for monitoring credit; sector risk; exposure to individual borrower; management of problem credits etc.
- Profitability and financial position: Historic profits, spread on fund deployment revenue on non-fund based services accretion to reserves etc.
- Interest and Tax sensitivity: Exposure to interest rate changes, hedge against interest rate and tax low changes, etc.