e

9.2 Traditional Credit Models

Credit scoring and credit ratings, two traditional approaches to credit risk analysis, apply to different types of borrowers.

The traditional approaches to credit risk (i) are widely used and (ii) provide a link between the traditional, financial statement-based credit analysis methods and the structural and reduced form credit risk models.

9.2.1 Credit Scoring and Credit Ratings

Credit Scoring – is used for small owner-operated businesses and individuals.

Credit Ratings – are used for companies, sovereigns, sub-sovereigns, and those entities' securities, as well as asset-backed securities.

Credit Scoring Credit scoring ranks a borrower's credit riskiness. It does not provide an estimate of a borrower's default probability.

The main features of credit scoring

  • It does not explicitly depend on current economic conditions.
  • It is not the percentile ranking of the borrower among a universe of borrowers.
  • It has different implications for the probability of default depending on the borrower and the nature of the loan that has been extended.
  • There is emphasis on credit scoring stability over time.

Credit scores are used in many markets in the world, but scoring varies considerably across markets. In some markets, only negative information, such as a default, is reported. Therefore, no score or information is positive because it means no news has been reported about the borrower.

In other markets, such factors as payment history and debt outstanding are used to develop a credit score, but the weighting of the factors can differ across countries.

Credit Ratings

  • Credit ratings rank the credit risk of a company, government (sovereign), quasi- government, or asset-backed security
  • Credit ratings do not provide an estimate of the loan's default probability. The number of rating grades and their definitions vary among third-party rating agencies and among financial services firms, but their objective is the same Create an ordinal ranking of borrowers by riskiness as an aid to portfolio selection and risk management
  • Rating agencies like Standard & Poor's and Moody's Investors Service use more than 20 rating grades, from AAA to D.
  • Internal ratings are created and heavily used by financial institutions to control their credit risk.
  • Major credit rating agencies are Standard and Poor's, Moody's Investors Service, and Fitch Ratings.

9.2.2 Ordinal Rankings

Credit ranking and Credit ratings – the two-traditional credit risk analysis approaches – are called "ordinal ranking" because they only "order" borrowers' riskiness from highest to lowest.

Lesson Wrap-Up

This lesson should leave you able to explain the traditional credit models in a fixed-income context and connect it to the decisions made by issuers, investors, or analysts.

Review Prompts

  1. Explain credit scoring and credit ratings in your own words.
  2. Explain ordinal rankings in your own words.
  3. State one exam-style risk, valuation, or market implication of the traditional credit models.