This document discusses some practical issues in assessing corporate credit risk. It notes that some common assumptions made by inexperienced lenders, such as that financial statements are always reliable, are not always realistic. It then provides some examples to demonstrate how to overcome these issues, such as having a more flexible definition of default that accounts for situations where borrowers exhibit financial weaknesses before a missed payment. The document also discusses domestic credit rating agencies and their role in providing credit ratings, especially in developing countries.

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Practical Issues In Credit Assessments
10
KEY CONCEPTS
• Domestic credit rating agency
• Financial distress
• Altman’s ZChina-score
• Earnings manipulation
10 Practical issues in credit assessments
10.1 Practical issues
Invariably, many less experienced lenders set up their corporate credit analysis
framework with some underlying assumptions:
• The default of a borrower is triggered on the due day when the full payment of
interest and/or principal is not on schedule;
• The major global credit rating agencies deliver credit ratings of most corporations in
the world under a similar standard;
• Historical default records are available for the development of credit scoring models;
• The credit qualities of corporations are explained by a universal set of financial ratios;
and
• Financial statements provided by corporations are reliable in characterizing their
financial healthiness.
However, these assumptions are at times less realistic: a lender may classify a borrower
as in default before the next due day if the borrower has already exhibited significant
weaknesses in his financial condition; the major global credit rating agencies issue a total
of fewer than twenty thousand corporate credit ratings every year; historical default
records are rare and difficult to collect; the credit qualities of corporations in different
countries and industries are explained by very different sets of financial ratios; and all
financial statements are subject to a certain degree of accounting cosmetics.
This chapter demonstrates how to overcome these issues. An example is illustrated to
assess the credit qualities of listed companies in mainland China.

2. 138 Managing Credit Risk Under The Basel III Framework
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10.2 Definition of default ★★★★★★★★★★★★
Although it is straight forward and objective to classify a borrower to be in default when
he fails to pay the interest and/or principal in full on schedule, such definition of default
is far from practice. In case a borrower fails to pay the interest and/or principal in full on
a due day, in practice, the borrower is classified as overdue instead of default. An
overdue period from several days to several months may be granted to the borrower at a
small penalty. During this overdue period, the lender will remind continuously the
borrower to pay the overdue amount immediately. If the borrower pays the overdue
amount during the overdue period, the borrower is resumed to survival from overdue.
However, if the borrower eventually fails to pay the overdue amount, the borrower is
classified as in default technically after the overdue period. This arrangement essentially
facilitates the customer relationship management from the lender.
On the other hand, in a situation where a corporation has declared bankruptcy, even
though the next interest payment will not take place until next year, a lender must classify
the borrower as in default and take immediate action to recover part of the principal and
interest.
Therefore, in practice, a more flexible definition of default must be imposed. Under the
Basel III framework, a borrower is considered in default when any one of the following
conditions emerges:
• A borrower has an outstanding debt overdue for over ninety days;
• A borrower’s outstanding debt amount, after incorporating the interest, has exceeded
the prevailing credit limit;
• A lender unilaterally reduces a borrower’s credit limit to an amount below the current
outstanding debt amount; and
• A lender is unlikely to recoup the interest and/or principal from a borrower in full
without taking recovery actions such as selling collaterals pledged by a borrower.
10.3 Domestic credit rating agencies ★★★★★★★★★★★★
Although the major global credit rating agencies set the de facto standard of credit ratings,
their coverage is largely confined only to developed countries. Other countries,
especially developing countries, limit the local operations of these credit rating agencies
for fear of potential economic intervention from other countries through credit ratings.
Instead, these countries encourage the establishment of their own domestic credit rating
agencies.
A domestic credit rating agency is a credit rating agency established with a primary
mission to provide credit assessment services to corporations in its home country. It