Credit Ratings

The ground rules for commercial lending are set to undergo fundamental changes. Detailed assessment systems for credit risks will become the norm, and the disclosure requirements for borrowers will increase. Under Basel II, credit ratings assigned to borrowers by independent agencies will become the definitive criteria for determining banks– capital requirements. The new regulations will place more stringent requirements on borrowers and affect the cost of capital. In view of the upcoming changes, now is a good time for commercial borrowers to focus on the issue of ratings, to prepare for stricter disclosure requirements and, most importantly, to ensure that their company or organisation has the best possible credit rating.

To help you get started, we have compiled the following information on credit ratings:

1. Basel II and what it means
2. What banks look for when making credit risk assessments
3. Rating symbols and what they mean
4. Who gives credit ratings?

Basel II and what it means

When advancing a loan, a financial institution is required to hold capital equal to a percentage (weighted by a risk factor) of the loan.

Capital requirement = credit amount x percentage x risk factor.

Basel I (the Basel Capital Accord of 1988 or Basel Accord) imposes a blanket 8% risk-weighted capital requirement on financial institutions. In other words, on a loan of –1 million, the lending bank would have to hold covering capital of –80,000. A drawback of this approach is that it treats all borrowers the same by charging them a roughly uniform interest rate that does not adequately reflect their individual creditworthiness. The current system penalises borrowers who have an excellent credit record and who operate in growth markets (by charging them excessively high risk premiums) and benefits borrowers with poor credit (by charging them excessively low risk premiums).

The idea behind Basel II is to bring bank capital requirements more closely into line with actual risk. In the news since their inception in 1999, the Basel II proposals are scheduled to take effect in 2006 at the earliest. Businesses, particularly SMEs, are well advised to use the intervening period to familiarise themselves with the new commercial lending regime.

Basically, Basel Il will retain the 8% risk-weighted capital requirement. However, the new risk weightings will more accurately reflect individual circumstances because they will be based on the borrower's individual credit risk assessment. For example, on a loan of –1 million, a company with a very good credit rating might have a risk weighting of only 20% (that is, 20% of the standard 8%, yielding a bank capital requirement of only –16,000). By contrast, a company with a poor credit rating might have a risk weighting of 120% (resulting in a bank capital requirement of –120,000). Under Basel II, therefore, financial institutions will charge more widely varying interest rates. SMEs that want to take advantage of the new system cannot afford to take a wait-and-see attitude. They need to start polishing up their credit rating.

What banks look for when making credit risk assessments

1. Management

• Quality of the company's management team
• Quality of the company's accounting and controlling systems

2. Market/industry

• Market and industry trends
• Customer base and supplier base diversification
• Export and import risks
• Intensity of the competition
• Products, product range
• Standard of service

3. Relationship with the bank

• Account history
• Borrower's disclosure history/policy

4. Financial position

• Assessment of borrower's financial statements
• Overall financial situation

5. Projected performance of the borrower's business

• Performance of the business since the last annual financial statements
• Quality of corporate planning
• Projected earnings and ability to repay the principal
• Special business risks

Rating symbols and what they mean

A credit rating is basically an assessment as to the ability of a borrower to meet its payment obligations as they fall due. Because its objective is to tie the borrower's creditworthiness to actual credit risk, Basel II will rely on the credit-rating classifications used by leading independent, international credit-rating agencies such as Fitch IBCA, Standard & Poor's, and Moody's. This means that the credit-rating classifications currently used for investment recommendations will be adopted to indicate the financial standing and creditworthiness of individual companies.

The table shows that the risk assessments underlying the ratings are comparable despite the agencies– respective rating symbols, methods, and systems. Ratings are usually done for the year ahead and take into account business and financial risks.

Who gives credit ratings?

External ratings

External ratings are given by agencies that are independent of the lending bank. In recent years a number of independent agencies specialising primarily in ratings for SMEs have sprung up in Germany. In addition the big international agencies, which until now have tended to specialise in assessing large corporations for investment purposes, have recently signalled their intention to adapt their credit rating systems to the needs of SMEs. The German agencies are still relatively new, and it remains to be seen which rating approach will become the German standard.

Below are some of the German agencies that perform credit ratings for SMEs:

Internal ratings

These are ratings performed by the borrower's bank. In its present form, Basel II expressly recognises internal credit ratings by financial institutions as well as external ratings. To be empowered to perform internal ratings, a financial institution must have its credit rating methods approved by the appropriate regulatory agency, make its methods public, and ensure that its ratings are comparable to the ratings of other financial institutions. Internal ratings by banks are hardly something new. In order to minimise risk, banks have been performing credit assessments on their corporate customers for years. The difference is that existing assessment regimes are largely restricted to evaluating the borrower's annual financial statements.

External and internal ratings

Your company will need to obtain an external credit rating if it intends to borrow directly on the capital market. An external credit rating is also a valuable tool for demonstrating your firm's creditworthiness to shareholders, suppliers, and customers (when benchmarking your company, when negotiating and fulfilling contracts, or when making direct comparisons with the competition). Financial institutions, on the other hand, will always perform their own internal credit risk assessment regardless of whether you provide them with an external credit rating.

Further information

You are invited to attend our information events on credit rating for SMEs. Expert advisors will teach you the fundamentals of credit rating and inform you about future rating requirements for corporate finance.