12 - Credit quality and independent rating agencies

Abstract

Every entity is exposed to credit-related losses in the event of non-performance by counterparties. Therefore, it is absolutely necessary to monitor creditworthiness of counterparties and their default likelihood. The term counterparty denotes an entity or person to whom the bank has an on-balance sheet and/or off-balance sheet credit or market exposure, or other type of exposure such as a legal one. With reregulation of financial markets that has come with globalization and the new supervisory rules and guidelines such as Basel II, investors have to substitute generalized crisis risk for the specific risks of individual transactions—from investments to other commitments. This chapter focuses on credit quality, credit risk, and credit rating. The credit exposure resulting from all types of financial transactions is the worth of contracts with a recognized positive fair value. By contrast, a negative fair value indicates the impact of market risk. “Credit” is a financial term with a moral lineage that goes beyond its meaning debt. Banks are classically doing credit evaluation of their borrowers but in the majority of cases the rating scale they are using is coarse-grain, with only a few thresholds that are not satisfactory. As far as credit quality of issuers and of debt instruments is concerned, investors rely on ratings assigned to corporate, sovereign, and other debt by independent rating organizations such as Moody's Investors Service.