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Lahore School of Economics

Credit Ratings

MBA Finance Lahore School of Economics [Spring 2013]


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Credit Ratings The Concept

The credit rating is a symbolic indicator of the current opinion of therelative capability of the issuer to service its debt obligation.

It enables the investor to differentiate between debt instrumentson the basis of their underlying credit quality

It is focused on communicating to the investors , the relativeranking of the default loss probability for a given fixed incomeinvestment , in comparison with other rated instruments.

Credit ratings is an opinion about the credit quality of a debtinstrument and is not a recommendation to buy or sell.

Credit ratings are generally based on publicly available information

and thus such opinions are subject to certain givens.


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Credit Ratings The Concept

In determining a rating , both quantitative and qualitative analysesare employed. The judgment is qualitative in nature and the role of

the quantitative analysis is to help make the best possible overallqualitative judgment because, ultimately , a rating is an opinion.

Standard and Poors

A rating is an opinion on the future ability and legal obligation of theissuer to make timely payments of principal and interest on aspecific fixed income security.

Moodys

Why Credit Ratings?

The main motivation for the establishment of rating agencies isthe recognition of their critical role in promoting bond or otherfixed income securities markets.


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Credit Ratings The Benefits

Benefits for Investors Ratings are taken as risk level associated with the fixed

income securities thus constituting an input for theinvestment decision.

Banks use ratings to support their own lending/investing

decisions. corporate treasurers are also using ratings to evaluate the

credit risk of banks, securities firms, and othercounterparties that offer swap transaction.

Benefits for Issuers

Low effective cost of raising debt. Benefits for Regulators

Financial Institutions are obligated to have credit ratingsfrom a recognised agency.


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Credit Ratings Benefit for

Banks Banks could save capital, depending on the

credit profile of their corporate exposures.

If a bank has high-quality assets (for example, if

the majority of its assets are in the 'AAA' and'AA' categories) it will save capital because oflow credit risk

Capital required is computed as loan amount xrisk weight x 9 per cent


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Credit Ratings The Benefits

Illustration of capital-savingpotential by bankson a loan of Rs.1000 Million

Rating Basel I Basel II

Risk weight Capital

required1

Risk weight Capital

required

Capital saved

(rs. mn) (rs. mn)

AAA 100% 90 20% 18 72

AA 100% 90 30% 27 63

A 100% 90 50% 45 45

BBB 100% 90 100% 90 0

BBand

below

100% 90 150% 135 (45)

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Credit Ratings Rating

Process Rating Process

Rating Mandate

Rating Team

Review of Public

Information Questionnaire

Plant Visit/ManagementMeeting

Information Receivedand Analyzed.

Final ManagementMeeting

Rating CommitteeMeeting

Report Sent to Client

Rating made public.

Rating is an interactive processrelying primarily in gathering

information from the issuer. The

entire process is aimed atevaluating

Financial Risk Funding Policies.

Financial Flexibility.

Business Risk Unsolicited ratings


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Credit Ratings Rating

Process

Funding Policies Future funding requirements Level of leveraging

Views on retainingshareholding control Target returns for

shareholders Views on interest rates Currency exposures

including policies to controlthe currency risk

Asset-liability tenurematching.

Financial flexibility Past financial

performance. Accounting quality.

Indicators of financialperformance

Profitability Level of leveraging Coverage ratios

Liquidity position Cash flow analysis Future cash flow

adequacy


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PACRA Rating Process

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JCR-V I S Rat ing ProcessI ssuer/ Client 1. Signs agreement for an initial rating2. Submits preliminary information materialsJCR- VI S 3. Conducts a preliminary study

4. Submits a detailed questionnaire to the issuer/client

I ssuer/ Client 5. Provides detailed information in response to detailed questionnaireJCR- VI S 6. Conducts pre due diligence meeting analysis

7. Conducts due diligence meetings4 - 5 w e e k s

JCR- VI S 8. Conducts post due diligence analysis9. Brief for int ernal rating commit tee meetings is prepared

10. Sub Committee recommends preliminary/initial rating

11. Rating Comm itt ee decides the preliminary/ initial rating 12. Discusses the rating rationales and rating issues with client 13. Notifies issuer of the preliminary/initial rating, deliberates on appeals by client, ifan y

I ssuer/ Client 14. Consents to release of preliminary/initial rating to the public in case of non-mandatory ratings

JCR- VI S 15. Releases the preliminary/ initial rating to t he press2 - 3 w e ek

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Second levelThird level

Fourth level

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Short Term Ratings

A1+ A1 A2 A3

Long Term

Ratings

AAA

AA+

AA

AA-

A+

A

A- BBB+

BBB

BBB-

BB+


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Rating Elements Indicative

Weight

1 Profitability / Performance 20.0%

2 Credit Risk 25.0%

3 Market Risk 5.0%

4 Operational Risk 1.5%

5 Funding 7.5%

6 Liquidity (contingency) 2.5%

7 Capital Structure 10.0%

8 Franchise & Diversification 7.5%

9 Management & Strategy 7.5%

10 Economic Environment 2.5%

11 Regulatory Environment 1.0%

12 Size 5.0%

13 Potential Support 5.0%

100.0%

Rating

Categories

Range (W.

Score)

7.5 Min. Max

1 AAA 92.5 100

2 AA+ 85.0 92.5

3 AA 77.5 85.0

4 AA- 70.0 77.5

5 A+ 62.5 70.0

6 A 55.0 62.5

7 A- 47.5 55.08 BBB+ 40.0 47.5

9 BBB 32.5 40.0

10 BBB- 25.0 32.5

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