Credit Risk IQ – In Depth

Large sophisticated banks set their own internal credit risk ratings in order to manage the credit risk of the counterparties they lend to. For example: whether to lend in the first place, how much to lend and how much to charge the counterparty.

Their credit ratings for counterparties are derived by credit risk analysts & statistical modellers taking into account a range of quantitative variables (as an example, for a Corporate this might include leverage and debt ratios from the company’s management and public financial statements) and qualitative factors (which could include for example brand value and stability of management). The ratings are regularly updated to reflect changes in each counterparty’s economic situation.

The ratings help banks manage their risk of non-payment (default or bankruptcy) from a counterparty they have lent to (default risk). These loans typically span many years, so the banks assessments look forward over the next year and evaluate the risk that the counterparty will default¹ over the next 12 months.

Each bank has developed & refined its own credit risk assessment & modelling process. Banks each have their own independent validation and review teams, who challenge the processes and review decisions. Banks’ models and rating processes are also subject to review by financial regulators (such as the Fed, EBA, Bank of England) and/or the banks’ own auditors.

Credit Benchmark receives from banks a 1-year forward-looking Probability of Default (PD) linked to the banks’ internal rating.

Credit Benchmark derives a Credit Consensus Rating (CCR) using the following steps:

• These PDs are averaged, to get the average view of the risk of the counterparty defaulting over the next year. This average view is called the consensus because it is a consensus opinion of the default risk of the counterparty.
• The consensus PD is mapped to a letter rating using a custom Credit Benchmark rating scale that has been calibrated using banks’ internal rating scales.