What Is an Internal Credit Risk Rating?

Credit risk ratings help companies differentiate good business partners from less creditworthy ones.

Credit risk rating is a business process meant to prevent a corporation from experiencing significant losses in its financial activities. An effective risk rating framework helps top management differentiate creditworthy business partners from "at-risk" ones, such as customers facing bankruptcy or experiencing temporary economic difficulties. A risk rating system also allows senior managers to allocate corporate resources adequately.

Cedit Risk Defined

Credit risk is the risk of loss that could originate from a customer's failure to reimburse a loan (default), or a business partner's inability to meet a financial commitment by the due date. For example, if an insurance company enters into an agreement to lend $10 million to a local businessman, and the businessman later files for bankruptcy, the insurance company might lose the loan amount. Alternatively, if the insurer expects the businessman's bank to guarantee the loan, and the bank also has temporary financial problems, this represents a credit risk for the insurer.

Risk Rating Tools

A corporate risk rating mechanism uses three methods to rank risks inherent in the firm's lending activities. First, a credit risk management specialist might apply statistical skills to build computer models that gather customer data and financial information and provide a classification. Second, the firm's internal audit department periodically might test credit risk processes to ensure they are operating effectively and adequately. Third, segment employees and departmental heads might evaluate internal controls in their areas and rank risks as "high," "medium" or "low" based on potential losses.

High Risk

High risk represents a risk of loss that can arise if a major process within a firm breaks. High risk typically brings about substantial losses if the "risk event" occurs. Assume an electronics store chain has one data center that processes all customers' information. The "risk event" is that the center cannot function because of a power outage or system breakdowns. In a power outage, the chain could face significant losses.

Medium Risk

Medium risk indicates a risk of loss relating to an important mechanism or procedure within a corporate department or region. Assume that our sample electronics store chain has 95 stores in the United States. In case of software malfunction or computer system breakdown in the Northeast, the company might incur losses, but not as great as in a high-risk situation.

Low Risk

A low-risk event relates to a corporate segment or a less significant process within a firm. Low-risk problems occur more frequently than high- and medium-risk ones. As an illustration, a nationwide store chain might have computer security problems at its New York regional headquarters. The company might treat this as a low-risk event.

References

• New York Institute of Finance: Credit Risk
• Harvard University: Center of International Development: A Structural Model for Sovereign Credit Risk
• Penn State University: Default Recovery Rates in Credit Risk Modeling: A Review of the Literature and Empirical Evidence