Management
4.6 Credit Risk Analysis and Rating System Structure
Table 4.7. Classification of credit valuation and rating assignment methodologies Basel
Committee categories
Nature of Credit valuation and Orientation process rating assignment methodologies
Judgment- Non- n.l. Traditional without pre- based structured established investigation areas and
without partial judgments referring to Bottom-up them
Constrained Expert Judg-
ment-based
Subjectively structured
Mechanical, based on subjectively
predefined weights
n.2. Traditional with pre-established investigation areas and with partial judgments referring to them, but with-
out standard weights per area
n.3. Subjective grids/scorings with pre- established weights for investigation areas identified by risk-factors(e.g.:
strategic, operating, financial, market, technological,..)
n.4. Subjective grids/scorings with pre- established weights for investigation areas identified by information sources (e.g.: balance sheets, internal trends, Credit Register data, industry, com- pany SWOT analysis)
n.5. Subjective expert
tems/grids/scorings with sys- established weights for indicators pre- Statistical
based
Statistical, based on indicators and weights
identified by statisti-
cal proce- dures Pure Top- down seg- mentation
n.7. Actuarial analysis
n.6. Statistical scorings and other simi- lar applications
Top-down
Source: De Laurentis (2001).
Table 4.8. Methodologies and risk classification in Italian banks Prevailing nature of credit valuation/rating
assignment processes in corporate area
Ratings as ordinal classification of credit risk Bank
B
D
H
Approach n.3 for qualitative section, n.6 for quantitative section. For small companies in- dicative weights are 30% and 70% respec- tively.
Approach n.2; automated procedures provide Being tested, the analyst with a "risk indicator" in any case.
Approach n.2
Only borrower rating is issued for each operation to be valu- ated.
Approach n. 1, though n.2 is now being con- sidered. Mechanical approaches are being implemented y in the retail business.
Almost exclusively mechanical approaches for small business; mostly automatic- statistical for SMEs (judgmental approach should account for 30%); CB should anyway develop personal analyses for his own com- mercial purposes. For large corporates auto- matic evaluation accounts no more than 50%
on the final assessment.
Approach n.5, (judgmental contribution is limited to 20%). Nevertheless, CBs are re- quested to produce analytical reports on bor- rowers' major profiles (accounting and Credit Register data, industry).
Approaches n.l and n.2 are prevailing and developed by credit area officers; statistical scoring is being introduced for small busi- ness.
After experimenting a mostly mechanical rating system, at present judgment involves credit analysts and loan offi- cers. The rating assigned by risk management unit serves as starting point for credit analysis. Borrower and facil- ity ratings are issued for large corporates. Pricing will be centralized for all segments.
Borrower rating assignment is being tested and approach is partially statistical and par- tially judgmental; target re- view frequency is annual.
Facility rating will be used for small business and borrower rating for SMEs. The ana- lyst's valuation does not af- fect the rating. The review will be monthly.
The system produces only a borrower rating; the review frequency is proportional to rating quality and ranges from six months to two years.
Only a borrower rating is as- signed.
This trend is also observed by Treacy and Carey (Strischek 1999) who, just one year earlier, had observed a clear predominance of methodologies more similar to the traditional ones: "in essentially all cases, the human judgment exercised by experienced bank staff is central to the assignment of rating. Banks thus design the operational flow of the rating process in ways that are aimed at promoting the accuracy and consistency of rating while not unduly restricting the exercise of judgment" (Treacy and Carey 1998)2. The limited mechanization of the rating process was also con- firmed by the generic nature of the written guidelines regarding rating formulation, by the lack of pre-established weights for the different risk profiles, by the presence of grids of relevant factors in a limited number of banks (whereas the majority of them required an extended written report of the reasons for the assigned rating). The rating assignment process turned out to be an "unwritten knowledge embedded in the bank's credit culture"
(Treacy and Carey 1998). Similar results have been obtained in other sur- veys3.
In the other European panel banks, probably owing to a) the larger us- age of the rating system well before the development of portfolio credit risk models which require cardinal measurements of risk and b) to the lar- ger size of corporate counterparts, the rating assignment process relies more substantially on judgmental analyses, which play a highly significant role compared to the more structured systems. For smaller-size companies, however, the latter become more relevant.
The trend toward mechanization in credit valuation processes bears mul- tiple consequences both in terms of the system and of the company. In the first group, along with a favorable discipline-effect among borrower com- panies, there may be a number of adverse phenomena: bank-company rela- tionships tend to become less flexible, credit tends to be considered a commodity and credit decisions are characterized by possible short termism with intensified pro-cyclic bank behaviors and difficult financing of medium-term corporate strategies. In the second group, along with the favorable effects of the squeeze in operative costs and process standardiza- tion, the following may occur:
2 The survey carried out by Treacy and Carey, representatives of the Federal Re- serve, is based on three information sources: the analysis of internal reports and of the documents regarding the credit policy of fifty among the greatest American banks, on the interviews to more than fifteen senior bankers in more than fifteen major banks and finally on the experience of the Federal Reserve inspectors.
3 They have been synthesized with a research on Italian banks in Basel Committee (2000), De Laurentis (2001).
a) weaker pressure to develop corporate analysts' skills which are neces- sary to meet companies' medium term investment needs;
b) lack of consistency with customized assistance/advisory approaches of corporate division; highly structured procedures that aseptically assess credit risk do not produce information spillovers for the selling of bank products/services. The concept of spillover here used refers to activities which may be performed by the same subject; the meaning is similar to that suggested by Baron and Besanko (2001): "know-how and skills in the performance of an activity that, when shared with other units in the firm, enable those units to perform that activity better than they would otherwise".
The tendency to automate underwriting techniques questions the basic principles of the lending relationships identified by Berger and Udell (1996) and by Petersen and Rajan (1994) in the unique information re- quirements typical of the small business lending and typically met by lo- cally based banks. Worries about the deterioration of bank-borrower rela- tionships and about credit availability are present in a large number of countries (Feldman 1997; De Laurentis 2001) but with contrasting empiri- cal evidence. Recent empirical surveys regarding small business lending (which, as mentioned in Chap.2, is managed by the corporate area in a lot of, above all, Italian banks) reveal that banks' intention to increase SME credit share is positively correlated with the use of scoring systems (Frame et al. 2001). The research carried out by Berger, Frame, Miller (2002) re- veals that the usage of scoring systems in the segment of small business (loans amounting up to US$100,000) raises both credit availability and price, both the market shares of small business lending in major banks and credit availability for higher-risk debtors; such effects are quite irrelevant for lending between US$ 100,000 and 250,000. It is worth noticing, how- ever, that the banks adopting scoring systems in this segment are far less numerous and only 8 of them are included in the surveyed panel; on the contrary in the United States scoring systems were widely implemented in the segment of small business lending already in the mid-nineties (Ely and Robinson 2001; Akhavein et al. 2001). As a result, in the small business lower loans segment a structural change seems to be involving credit sup- ply and banks' roles: customer proximity is bound to become meaningless, competitiveness is bound to grow and the competitive advantage seems to be connected with the ability to become cost leader.
Nevertheless, banks' stated mission and most of their actual choices re- garding the organization and management of corporate banking seem to be customization-oriented. As to credit risk management, it is important to es- tablish the extent to which non-public information determines corporate
ratings. Research is still quite limited. Brunner, Krahnen, Weber (2000) on the one hand have observed that during the '90s all of the five major Ger- man commercial banks being investigated standardized credit approval procedures on the basis of credit scoring systems, on the other they have confirmed that the set of qualitative, or soft, factors is not redundant with respect to publicly available accounting data. Rather, qualitative informa- tion tends to be decisive in at least one third of the cases.
If we now consider our panel banks, we can see that in several cases rat- ing assignment is still to be suitably integrated in the operative processes of loan approval. As a consequence, the compliance with Basel's provi- sions as to the rating system validation for the measurement of capital re- quirements will need some organizational refinements. Let us consider the following paragraphs of The New Basel Capital Accord Consultative Document dated April 2003, which contains the most recent version of the proposal of a New Capital Accord 4: "For corporate, sovereign, and bank exposures, each borrower and all recognized guarantors must be assigned a rating and each exposure must be associated with a facility rating as part of the loan approval process. Similarly, for retail, each exposure must be as- signed to a pool as part of the loan approval process" (paragraph 384);
"Rating assignments and periodic rating reviews must be completed or ap- proved by a party that does not directly stand to benefit from the extension of credit. Independence of the rating assignment process can be achieved through a range of practices that will be carefully reviewed by supervisors.
These operational processes must be documented in the bank's procedures and incorporated into bank policies" (paragraph 386); "Internal ratings and default and loss estimates must play an essential role in the credit approval, risk management, internal capital allocations, and corporate governance functions of banks using the IRB approach. Ratings systems and estimates designed and implemented exclusively for the purpose of qualifying for the IRB approach and used only to provide IRB inputs are not acceptable"
(paragraph 406).
The lack of integration of rating systems into loan approval processes ("double way approach") can be explained by two main reasons. The first, acceptable, provides for a transitory stage before ratings become "opera- tional". The second, not acceptable, considers ratings as mainly mechani- cal processes for estimating the borrower's default probability or the op- eration's expected loss designed to feed credit risk models and to manage loan portfolios, while leaving the wide range of traditional evaluations and the usual roles entrusted with credit investigations, proposals and approv- als of single loans.
Basel Committee on Banking Supervision (2003).
In the other European banks the problem seems to be less serious: the rating system is in fact better integrated in credit management and the ap- proval processes carried out by credit structures and it affects the price (banks Y and Z) as well as the credit amount; in two banks (W and X) the officer with significant lending authority keeps contacts with customers by working outside the bank premises for about 20%-35% of his time.
The time horizon varies in the banks surveyed with no precise relation with the more or less mechanical nature of the methodologies imple- mented. It ranges from six months to the entire length of the operation, with the one-year prevailing choice; the two-year period is indicated for larger-size or higher-risk customers and medium term loans. In most of the Italian and other European banks, however, the target time-horizon is not explicitly declared to officers and the conceptual distinction of the three relevant time profiles is not immediate(the frequency of reviews, the quan- tification of defaults/losses and the time horizon targeted in the assignment processes). As a result, the position of the Basel Committee is useful as it makes clear that "although the time horizon used in PD estimation is one year (as described in paragraph 409), banks must use a longer time horizon in assigning ratings".5
Let us now consider the set of information regarded as relevant by the Italian banks for credit risk exposure (Table 4.9).
Table 4.9. Relevance of information sources/typologies for reliability judgment Prevailing replies*
Guarantees and corporate assets L-M-H Balance sheet indicators M Personal knowledge of the borrower; External information (specialized H agencies, clients, suppliers, banks, stock exchange market); Qualitative information on company's business plans and on organizational and technological situation; Qualitative and quantitative analyses on sector structural characteristics and on rules of the competitive game entered by the company
Bank relationship and Credit Register's data M
•"Importance H=High, M=Medium, L=Low
5 Ibidem, paragraph 376. The Basel Committee confirms the necessity to avoid confusion between rating assignment processes and rating quantification processes (De Laurentis, 2001, Chap. "II processo di rating quantification").
We can observe: a) opinions are quite differentiated as to the profiles of guarantees/capital analyses with no prevailing replies; b) opinions are con- cordant as to the importance of other information sources; c) qualitative in- formation is highly relevant in all banks.
As for the relative importance of the analyses on liquidation values of collaterals/guarantees and corporate assets (i.e. on LGD, loss given default, that is the loss rate in case of counterpart's default), banks have quite dif- ferent opinions, almost equally distributed among those who retain such valuations highly, medium or little important in the corporate segment. Ce- teris paribus, the relative importance of the guarantees is higher in smaller size customer segments.
The information deductible from the company balances is given me- dium or high importance by all the banks except for one, which remarks the poor reliability of financial statements; the analysis, however, is carried out by comparing one company's balance sheets in the course of time by means of financial ratios, whereas a very low incidence has been observed for synoptic valuations designed to compare one company's performances with that of others or with average data from significant aggregates of cor- porates. On the contrary, it is evident the assignment of risk ratings is based on the comparison of different borrowers and, hence, the synoptic analysis is bound to become more important at least in the banks which will not rely exclusively on mechanical procedures for their balance valua- tions.
Qualitative analyses are on the whole considered very important but there is a certain difference among banks as for the single aspects. More specifically, the role assigned to "personal knowledge of the borrower" is high in two banks (above all for smaller-size corporate clients) and low in another three banks.
Analyses of bank relationship and Credit Register data are given me- dium or high relevance, except for two banks. Note that if such informa- tion is given much too relevance in the traditional valuation process or in the mechanical processes often utilized to synthesize quantitative data, the entire risk valuation process is characterized by poor forecasting ability. In fact, due to their own nature, such information sources: a) concern infor- mation showing companies' difficulties with great evidence, but only after their actual entry in cash flow drains and higher indebtedness status; b) give account of the company's behavior in relation to lending banks; in other words they are not original data, that is exogenous to banks' credit decisions, but they reflect lending banks' perception of borrower risk: this is reflected information (comparable to data used in the technical analysis for security investments decisions and, thus, different from the informa- tion used for the fundamental analysis); c) the better the company the less
significant the information they provide.
As for the three other European banks providing indications about the information sources they consider important for credit risk analysis, we can observe the following situations: Bank W gives very little importance to guarantees and corporate assets, medium importance to balance sheets and great importance to company and sector qualitative aspects; Bank X, on the contrary, gives significant importance to balance sheets and guaran- tees; both banks consider bank relationship and Credit Register data rela- tively little important; Bank V gives great importance to balance sheets (both historical and synoptic) analysis, sector strategic analysis and credit behavioral data.