Credit Risk Assessment Framework

The credit Risk Assessment Framework is a set of broad guidelines that allow rating agencies to standardize the process of rating over time to assign credit rating more accurately considering various credit risk factors. Assignment of credit ratings is a subjective, time consuming, and constantly changing process. There are many factors a Credit Rating Agency would analyze while rating an organization.

This week we will explore about Credit Rating Assessment Framework in brief, with an aim to provide insights into the approach of the rating agencies while assigning ratings to an organization.

What is Credit Risk Assessment?

Credit Risk Assessment is a process of assessing the risk to understand the probability of default in repayment of any debt. The credit risk assessment is a process of understanding the various risk factors and their impact on the debt repayment capacity of an organization to determine the likelihood of financial obligations being served on time. 

The credit risk assessment is a process to determine the fundamentals of the organization and the probabilities of change in these fundamentals, which could affect the creditworthiness of the organization.

What is being rated, a debt Instrument or an organization?

The credit risk assessment is the process through which a rating agency analyzes the relative probability of default of various debt instruments of an organization. An important distinction here is that the rating is assigned is NOT to an organization but to a particular debt instrument of an organization depending on the seniority and contractual terms of the debt instruments.  

So why do we need a Credit Risk Assessment Framework?

The framework provides a broad guideline to the analyst team. The common goal of this framework is to standardize the process of razor assessment and give stakeholders a a persistent view on the fundamental factors based on which credit rating is assigned.

The Framework:

Credit Risk Assessment involves an analysis of qualitative and quantitative factors affecting the creditworthiness of an organization. The framework for assessing the credit quality of an organization entails the four broad areas of Business Risk Assessment, Financial Risk Assessment, Industry Risk Assessment, and Management Risk Assessment.

Standard parts of risk assessment framework

• Industry risk
  • Industries come in various shapes and sizes so it indicates how the Credit will perform.  Industry risk includes growth prospects, cyclic ability, competitive intensity, and regulatory risk to define overall industrial risk factor.
•  Business risk
  • Business risks include scale of the industry, its market position & portfolio diversification, its operating efficiency, and projects.
•  Financial risk
  • Financial risk measures profitability, leverage, coverage and cash flows with liquidity into account. Statistical approach in financial risk calculation is useful to represent facts and its generally easy to identify.
•  Management risk
  •  Quality of Management, financial policies, governance structure and practices fall under the management risk.  The management risk defines the trust factor between borrower and lender.

Framework’s significant for borrowers: 

Now, you might be wondering, what it has to do with me as a business person? Well, it has everything to do with a business rating and so it has to do with you. The most prominent benefit of understanding the framework is it helps you to comprehend the risk assessment process of rating agencies. Through, the framework, an organization is able to understand the factors on which the rating outcome is dependent.

Conclusion

The credit rating of an entity is governed by the degree of its exposure to industry risk, business risk, financial risk, and management risk. The credit risk assessment framework describes broad parameters that a rating agency looks into while assigning ratings. This framework provides an overall perspective of the considerations that are usually the most important. The relative impact of each of these broad risk categories on an entity’s credit risk may vary from case-to-case and is assessed by a rating agency based on pragmatic and qualitative judgment.

Understanding the framework is very important for an organization to recognize the factors on which rating outcome is dependent.

Further

We will be covering each of the framework risk factors with details in upcoming articles. As a credit rating consultant, ACC Ratings aims to bring the best possible solutions to the complex processes of ratings. Stay tuned!

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