Credit risk management models and analysis: a case study

Abstract

Credit Rating is an independent, professional opinion given by a specialized agency, on the borrower s ability to repay the principal and pay the interest on time as per the terms of the instrument. In the recent few years, there has been a lot of criticism on the ratings given by credit rating agencies. Hence, it becomes important to test the reliability of the credit ratings. The project examines the significance of testing the intrinsic rating model of the financial institution used to estimate the credit rating of the counter party and credit risk associated with the obligor. Every major financial institution has its own internal models based on the various accounting ratios derived from financial institutions of the obligor. The other parameters which are used as inputs to the rating model could be environment assessment, industry assessment, country rating and management assessment. The project involves using multivariate statistical techniques to analyze the effectiveness of internal rating model of a European bank. With the new Basel capital accord bank regulators are proposing the use of quantitative measures while evaluating the eligibility of intrinsic rating methodology for the internal ratings based approach. Banks which don t discriminate high- and low-risk borrowers ends up in increasing their average capital requirements due to concavity of the capital requirements function. In the project various credit ratings assigned by the bank is used to create a map between the internal ratings and Z-Scores to develop a form of Z-score model. The equation is developed by analyzing the internal credit rating model of the bank and ratios selected are: gross gearing, sales, EBITDA margin, net debt-to-EBIDTA ratio and EBIT Interest coverage. In the equation the coefficients are calculated using the sample size of 80 listed companies. The chi-square test on the calculated Z-score with reference to benchmarked score from the map arrived by the bank will depict the effectiveness and accuracy of the rating model. As probability of default forms one of the major elements of new IRB approach to credit risk assessment for estimation of the risk capital, we estimate the PDs of 60 listed Indian companies using the Merton s Option Pricing Model. Using the calculated PDs we then identify appropriateness of using IRB approach for credit ratings of various companies in India