The optimal rating philosophy for the rating of SMEs
AbstractThe 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.
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Bibliographic InfoPaper provided by Vlerick Leuven Gent Management School in its series Vlerick Leuven Gent Management School Working Paper Series with number 2007-10.
Length: 39 pages
Date of creation: 27 Feb 2007
Date of revision:
rating philosophy; small business; Basel II; credit rating; banks;
Find related papers by JEL classification:
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
- G20 - Financial Economics - - Financial Institutions and Services - - - General
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
- G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-03-24 (All new papers)
- NEP-BAN-2007-03-24 (Banking)
- NEP-MAC-2007-03-24 (Macroeconomics)
- NEP-RMG-2007-03-24 (Risk Management)
You can help add them by filling out this form.
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