Credit Rating denotes, broadly speaking, a summary Credit Risk indicator (also Credit Risk Rating) that assesses the Risk Profile of an entity or product on a defined Rating Scale. Most typically a credit rating is an assessment of Creditworthiness of a Corporate Borrower generally or with respect to a particular debt or financial obligation (Ability and Willingness to Pay).
- A credit rating is a subjective opinion offered by a specific entity (for example a Credit Rating Agency).
- A credit rating is intrinsically a forward looking opinion. Some of the information underpining the assessment will have a (more or less) empirical basis and could e.g., be verified to some degree of certainty, but very significant elements of forming a rating opinion will reflect projections about likely futures.
- A credit rating is an independent opinion aiming to address the Asymmetric Information between borrowers and lenders.
- A credit rating is a competent opinion. In principle anyone possessing adequate credit related information about a borrower and a fit-for-purpose Credit Rating Methodology can produce such a opinion.
- Different jursidictions may impose regulatory requirements around the production and usage of credit ratings (See below).
Credit ratings, scales, along with other quantitative and qualitative tools and methodologies form together a Credit Rating System. Typically, a credit rating is provided as a detailed report based on the financial history of borrowing or lending and creditworthiness of the entity or person derived from income statements, historical records related to borrowing, etc. with an aim to determine their ability to meet debt obligations.
Internal credit ratings are typically produced by firms or organizations engaging in lending operations. External credit ratings are produced instead by specialized entities
Credit Rating Types
Credit Ratings can vary widely in nature. They can be categorized along several dimensions, reflecting the fact that a relatively simple labelling framework is applied across a large variety of different credit relationships:
- The type of Credit Event (or events) captured (Default Definition)
- Whether they concern Probability of Default of Expected Credit Loss
- Whether they concern a long or short term risk assessment
- Whether they concern an issuer or a specific Debt Instrument risk assessment
- Liabilities of regular entities versus liabilities of special purpose vehicles (structured finance / securitization)
- The type of issuer. Typical subcategories reflecting the peculiarities of different legal entities are
- Insurance Companies
In the context of Credit Rating Agencies Regulation, credit rating means an opinion regarding the creditworthiness of an entity, a debt or financial obligation, debt security, preferred share or other financial instrument, or of an issuer of such a debt or financial obligation, debt security, preferred share or other financial instrument, issued using an established and defined ranking system of rating categories (Regulation 1060/2009 Article 3(1)(a)).
Issues and Challenges
Over the course of several decades of application credit ratings have revealed various pathologies. They can categorized broadly along the following two lines:
Relating to the Credit Rating concept itself
- Ability to capture (be risk sensitive) the stated risk
- Ability to communicate unambiguously the meaning of the rating
Relating to the organization of Credit Rating issuance by third parties
- Availability of adequate information to form fit-for-purpose ratings
- Prevalence of the right incentives to form fit-for-purpose ratings
- ↑ ESMA
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