Credit risk management

1. Managing Credit Risk Under The Basel III Framework 85
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Credit Ratings and FICO Scores
7
KEY CONCEPTS
• Credit rating agency
• Credit rating
• Default rate
• ECAI rating scale
• Credit bureau
• FICO score
7 Credit ratings and FICO scores
7.1 Credit assessment ★★★★★★★★★★★★
In Chapter 2, the credit risk factors of and their impacts to four common credit products
are examined. A lender can design a credit product that matches his risk-return and
investment horizon preferences by selecting the right mix of the EAD, LGD and initial
RM. In addition, the lender chooses to lend only to a borrower with credit quality
conforming to his preference, having considered the objective evidence provided by the
borrower. This process of discovering the credit quality of a borrower with some
objective evidences is referred to as credit assessment.
Credit assessment seeks to answer the following two strategic questions:
• Is the borrower a good borrower (e.g., likely to survive during the lending period) or a
bad borrower (e.g., likely to default during the lending period)? If the lender will
review and control the credit risk of the debt at the end of the following one year, the
latest, a unified hypothetical lending period of one year may be assumed; and
• What is the PD of the borrower?
In real lending practices, huge amounts of resources are spent on credit assessments,
having regard to various types of borrowers, the lender’s technical expertise and the
availability of relevant information. The prevailing credit assessment techniques are
summarized in Figure 7.1 and will be explained in detail in Chapters 7 through 9.
For economic and practical reasons, many lenders leverage on credit assessments
conducted by independent experts to eliminate the repeated assessment efforts by
individual lenders. This arrives at credit ratings for corporate borrowers and FICO scores
for retail borrowers.
In accordance with the credit assessment techniques and available information, borrowers
are classified into:
• corporate borrowers, which cover listed companies and private firms; and
• retail borrowers, which cover individual persons and small businesses.

2. 86 Managing Credit Risk Under The Basel III Framework
Copyright 2018 CapitaLogic Limited
These two groups of borrowers take very different positions in the lending market, thus
driving the separate developments of credit rating agencies and retail credit bureaus.
Figure 7.1 Credit assessment techniques
7.2 Credit rating agency
A credit rating agency is an independent expert that assesses the credit quality of a
corporation with standardized procedures and presents the assessment result in the form
of a rank, referred to as a credit rating. This credit rating is shared among many lenders
who are interested in conducting lending businesses directly or indirectly with the rated
corporation.
Credit assessment for corporations is highly technical and relatively difficult to be
mastered by lenders without sufficient expertise and experience. A lender thus relies
invariably on a credit rating from a credit rating agency as one of the major inputs to
determine the credit quality of a borrower, leaving the lender’s resources to focus on
business functions in which he finds more important and/or competent.
The market of credit rating is dominated by three major global credit rating agencies,
namely:
• Moody’s Investors Service;
• Standard & Poor’s; and
• Fitch Ratings.
Some credit rating agencies specialize in certain particular industries or geographic areas,
e.g., A.M. Best is famous for its specialist credit ratings of insurance companies and
Dagong Global Credit Rating concentrates its efforts on credit ratings in mainland China.