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Credit rating: models and applications (part 2)

Thursday 13, 02 2020
For businesses themselves, credit rating is a measure of their reputation and development ability in the future.
Credit rating: models and applications (part 2)

In the world, corporate credit ratings are widely used in the field of finance and banking, and have different meanings depending on the purpose of each user.

For investors

Credit ratings can serve as a basis for decision making. For investors, credit rating information gives investors an in-depth understanding about the financial situation of businesses that investors are interested in. This is a useful channel for investors, especially when there is asymmetric information. Assessments and views of credit rating agencies are more objective than information that enterprises themselves show to the public. In addition, credit rating also measures the level of risk in a relative way depending on the purpose of the investor. The higher the credit rating, the lower the risk. Therefore, based on credit ratings, investors can compare investment potentials among businesses, determine the level of risk when investing, and make investment decisions.

>> Credit rating: what you need to know

For banks and financial institution

In the currency and derivatives markets, credit ratings help banks and funds determine the potential of their partners. When cash is abundant, banks and funds often lend or invest in trading instruments. Therefore, they use credit ratings as a basis to identify partners' risks easily and quickly before issuing a loan or making an investment. In swaps, it is especially important to know the risk of counterparties because the maturity date can be very long. An example of using credit ratings as a channel to find partners is that in the OTC derivatives trading market, the International Swaps and Derivatives Association (ISDA) have made an agreement on market entry. However, in the context of a number of major international banks being downgraded, many banks only enter into the ISDA agreement with partners rated by reputable credit rating agencies. A credit rating downgrade may result in the termination of the ISDA agreement if the rating falls below the previously announced limit.

In addition, credit ratings play an important role in advising investors about portfolios. The determination of asset allocation depends on the expected level of income and the level of risk tolerance. Credit rating is an easy way to explain the difference in the risks of investments. Banks, financial planners or hedge funds may offer advice based on credit rating results.

Credit rating also helps banks to manage collaterals and deposits. Most central banks require certain minimum ratings for institutions that issue any type of potential collateral. Banks or other financial institutions also rely on credit ratings when determining whether a collateral is acceptable. The credit ratings of a first-time escrow company is also used as an input to determine the margin level. The higher the ratings, the lower the margin.

​>> How does credit rating affect businesses?

For regulators

Credit rating is the basis for making financial regulations to ensure the stability of the financial sector. Credit ratings are used to monitor bank prudence, helping to determine the quality of debt securities or interest rate risks. This is set out in the standardized method of market risk in the Basel Agreement by the Basel Committee on Banking Supervision (BCBS).

In the international regulations on financial safety for financial and credit institutions, the Basel Accords established rules on capital requirements for banks in which banks must have a minimum amount of capital for all loans provided. This amount depends on the credit rating results from a credit rating agency approved by the External Credit Assessment Institutions (ECAI). Currently, many countries in the world have adopted Basel III, and accordingly, have assessed a number of measures to reduce dependence on external independent ratings within the framework of Basel II, enabling banks to perform internal credit ratings on externally rated securities transactions.

Credit ratings are used to make financial regulations in many countries. A BCBS’ investigation of whether regulators use credit rating results in making financial regulations shows that credit ratings are used in most investigated countries. Financial regulations are usually made as follows: requirements for capital of banks; requirements for information about securities portfolios of banks according to credit ratings; requirements for banks to reassess and record the fair value of bonds with credit ratings below the BBB level, etc.

For rated businesses

Credit rating is a tool to control the qualities of enterprises. In addition, in order to maintain high credit ratings, businesses must build a feasible business and production plan, at the same time improve operational efficiency, making profits to perform financial obligations well and ensure timely repayment of principal and interest. Therefore, credit ratings motivate businesses to find ways to use capital effectively, improving their competitiveness.

Credit rating helps businesses enter the market and get listed. In the Netherlands, if a business wants to mention their ratings in the white paper, the rating must be from a Europe-registered credit rating agency. This requirement must be fulfilled prior to the initial public offering. There is no requirement for a credit rating when issuing bonds but having credit rating results is still a common practice when issuing bonds, making it possible for third parties to review the the issuer. The latest credit rating regulations even require the use of at least two credit rating agencies when rating structured financial instruments.

Credit rating: models and applications (part 2)

For business support activities

The goal of corporate credit rating is to control risk, and limit its impact to the extent permitted. The forecast and early warning will prevent businesses from falling into a state of bankruptcy, ensuring businesses to have a safe state. In addition, when an enterprise accurately assesses financial risks, it will operate stably, increase the trust from capital sponsors, reduce credit risks and thereby reduce borrowing cost. Finally, when reducing the risk of bankruptcy, it means that businesses will avoid encountering complicated law-related problems such as disputes, litigation, ensuring legal compliance.

From the above reality, corporate credit ratings have shown an extremely important role in supporting businesses to have easier access with capital to meet production and business needs. In the course of production and business, to maintain continuous operation, enterprises must have sufficient capital in all three stages: storage, production and circulation. The temporary excess and lack of capital often occurs in businesses, especially in small businesses. Meanwhile, the easy access to credit will contribute to the regulation of capital sources to facilitate production and business processes, so that businesses can accelerate production as well as product consumption.

Corporate credit rating information also gives the Government a basis for comparing economic sectors, thereby knowing the level of risk in each industry, economic region and form of business. This is also the foundation for the Government to issue appropriate policies and solutions to help and promote the development of enterprises.

>> Credit rating: models & applications (part 1)


References:

1. Investor Bulletin: The ABCs of Credit Ratings [Online]. U.S. Securities and Exchange Commision.
2. NCIF (2017), "The role of corporate credit rating in implementing policies to support Vietnamese SMEs"

Henry Tran - VietnamCredit

Categories:
Credit Rating

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