credit risk rating

[shanlane]

Hello,

I understand what credit risk is and what the ratings mean, but sometimes the vocabulary seems little vague. For instance, in video 6d, you say that a lower risk rating is given to an asset with a longer tem to maturity. I hate to even ask this question because I feel a little silly doing so, but when you say a "lower risk rating", do you mean that the risk is lower (so it should actually earn a higher rating) or that the rating is lower (BBB vs AA)?

Sorry for the dumb question, but I just had to ask!

Thanks,

Shannon

 

[David Harper CFA FRM]

Hi Shannon,

That's from the Ong assignment, where I perpetuated his failure to actually explain the risk rating.

He is referring to the bank's internal credit rating. We can refer to an S&P or Moody's credit rating as external; the ECB even uses "External" in referring to them as ECAIs http://www.ecb.int/mopo/assets/ecaf/ecai/html/index.en.html

Compare to the bank's internal rating system, which would be mapped to external ratings; e.g., our internal rating of 1 ~= AAA; 2 ~= AA

I can never find anywhere that Ong actually explains his use of these internal ratings, maybe his explain is somewhere in the book, but he clearly implies an internal rating where risk rating (RR) = 1 is best (~ AAA) and RR = 5 is lower credit quality (i don't know where that maps or if it is the lowest). So, this is confusing as internal rating (higher number) --> lower credit quality --> lower S&P/Moody's rating

but, generally (in my opinion) "lower" almost always connotes a worse credit quality --> higher PD --> and, in this case a lower internal rating (a higher number, unfortunately).

So obviously it is not silly but sort of confusing!

I am very rusty on actual bank practices w.r.t. the internal ratings, I wish I knew what current bank best practices are (e.g., do they tend to assign 1 - 5; 1-10?)

Thanks,

 

[shanlane]

Thanks! If I may pose a quick follow up to that question, in that video it states that a "lower risk rating is given to an asset with a longer tem to maturity." So, from your explanation above, this means a security with a longer maturity has LESS risk? This seems counter-intuitive, unless I missed something. Sorry if I am making this a lot more confusing than it actually is.

Thanks again,

Shannon

 

[David Harper CFA FRM]

Hi Shannon,

No worries, but your intuition is correct! The video presents Ong (I am not original ) and Ong is referring to a bank's internal risk rating. Consistent with your intuition, he is saying that a bank will (should) assign a lower internal credit class rating (I realize now that is why he labels it RC; RC = risk class) for longer maturities; i.e.,

"By assigning a lower internal risk rating to a longer-term asset than to a shorter-term asset, effectively banks have been able to assign a higher default probability to longer term assets over the horizon" - Ong p 122

In short: Higher maturity -> LOWER credit quality --> Lower internal risk rating/class (RC) --> (eg.) RC 3 to RC 5, where RC 1 is best quality (~AAA)

btw, the Basel Advanced IRB similarly adjusts for maturity: the baseline is 2.5 years (FIRB) and maturities longer than that inform a slight multiplier up (increase) in the PD. In that case, not via "lower internal ratings" but both increase the PD. I hope that explains, I think what confuses me too (!) is that RC 3 to RC 5 is a higher value but we don't refer to it that way, going from Ong's RC 3 to RC 5 is a move to a LOWER credit quality (and higher PD). Thanks,

 

[shanlane]

That makes perfect sense.

Thanks!

Shannon