The Optimal Rating Philosophy for the Rating of SMEs

Abstract

The objective of this research is to determine the optimal rating philosophy for the rating of SMEs, and to describe the consequences of the chosen philosophy on several related aspects. As to our knowledge, this is the first paper that studies the considerations of financial institutions on what rating philosophy to adopt for specific portfolios.The importance for banks to have a solid risk framework to predict credit risk of their counterparties is well reflected by the quality and the quantity of research on this subject. Moreover, a good risk framework is vital to become compliant with the new Basel II framework.Problem is that financial institutions nearly always neglect the first step in the rating model development process: the determination of the rating philosophy. It is very important for financial institutions to decide whether they want their internal rating systems to grade borrowers according to their current condition (point-in-time), or their expected condition over a cycle and in stress (through-the-cycle), because the rating philosophy influences many aspects such as: credit approval, pricing, credit and portfolio monitoring, the regulatory and internal capital requirements and the competitive position of a bank. This makes the question which rating philosophy to use very important.Moreover, many different modelling techniques exist to determine credit risk, but few attempts have been devoted to credit risk assessment of small commercial loans, although SME exposures are relatively important for European banks. SMEs have specific characteristics that influence the rating philosophy and therefore the development and use of credit risk models. These SME characteristics are taken into account in the analysis to determine the optimal rating philosophy.

Foundations of Banking Origin and Social Rating Philosophy—A New Proposal for an Evaluation System

“…Social impact investing, stemming from the social and sustainable finance literature [1][2][3][4], has recently been gaining widespread recognition [5]. The number of specialized conferences and publications is increasing [1,8] by both academics (among others [6,[9][10][11][12][13][14][15]) and practitioners [16][17][18][19]. The major reason that drives the market and institutional interest in social impact investing is that investors can pursue financial and social goals simultaneously [20].…”

“…It is very important to define the kind of information the rating intends to summarize [66] and, therefore, to understand whether the rating systems must be more quantitative-oriented, qualitative-oriented, or follow a mixed approach. As stated by Rikkers and Thibeault [8], without knowing the rating philosophy it is difficult either to interpret whether the rating models match the (pre)defined philosophy, and what the consequences are of using a model with a specific philosophical basis.…”

“…A model of social impact should respect both the general characteristics of a risk model (such as powerful, accurate, statistically robust, reliable, intuitive and transparent, adhering to counterparty risk) and have its own: be farsighted; be sensitive to the socio-economic cycle; be economically efficient; be fast; be able to work only with limited data; widely applicable [8,70].…”

“…As the impact of FBO's activities is measured in both financial and social terms simultaneously, this calls for new evaluation metrics that overcome the classic risk-return dichotomy and introduce the dimension of the social impact that the investment is able to create. Therefore, drawing on the social rating philosophy [8] and inspiring from credit rating and sustainability ratings, the work proposes a social impact rating system able to mix quality parameters with social content with financial metrics. We suggest that a such rating cannot be a black box, but should be able to raise the quality and robustness of the decision making process by reducing the complexity of analyzing the attractiveness of investments and reducing the cost of financing for the best-rated projects thanks to the application on a reward mechanism.…”

Bank Credit Risk Management and Rating Migration Analysis on the Business Cycle

“…An important feature of external agency ratings is that, assuming time-homogeneity, they are assigned typically with a "through-the-cycle" (TTC; also, "stressed ratings") approach, based on an undefined long-term perspective on credit risk but of a more stable perspective [8]. This implies an evaluation of the borrower based on a downside scenario (e.g., the worst phase in the macroeconomic cycle) rather than on current market conditions, as in the so-called "point-in-time" (PIT) approach [9,10]. TTC ratings, therefore, tend to be more stable than PIT ratings, as rating transitions (migrations)-i.e., movements from one rating class to another-are less frequent.…”