Credit Rating

From Open Risk Manual

Definition

Credit Rating denotes a summary Credit Risk indicator (also Credit Risk Rating) that places the risk profile of an entity or product on a defined Rating Scale

Usage

Credit ratings, scales, along with other quantitative and qualitative tools and methodologies form together a Credit Rating System. A credit rating can in principle be produced by anybody possessing adequate credit related information about a borrower.

Legally [1], a 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))

Internal credit ratings are typically produced by firms or organizations engaging in lending operations. Enternal 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:

  • 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
    • Banks
    • Insurance Companies
    • Corporates
    • Municipalities
    • Sovereigns

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

  1. ESMA, Report on CRA Market Share Calculation, 2017

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