Prototype risk rating system

Abstract

This paper explores the traditional and prevalent approach to credit risk assessment – the rating system. We first describe the rating systems of the two main credit rating agencies, Standard & Poor's and Moody's. Then we show how an internal rating system in a bank can be organized in order to rate creditors systematically. We suggest adopting a two-tier rating system. First, an obligor rating that can be easily mapped to a default probability bucket. Second, a facility rating that determines the loss parameters in case of default, such as (i) “loss given default” (LGD), which depends on the seniority of the facility and the quality of the gurantees, and (ii) “usage given default” (UGD) for loan commitments, which depends on the nature of the commitment and the rating history of the borrower.