Weigh internal ratings against external ones, noting the strengths of each.
The idea
External ratings are independent of the lender, comparable across institutions, backed by long default histories and widely understood. Their weaknesses are that they cover mainly large rated issuers, change infrequently, use a through-the-cycle philosophy and lag market information. Internal ratings can cover private firms and small businesses that agencies ignore. They use private information from the lending relationship, such as covenants and account behaviour, and they can be updated often. They can also be tailored to the bank's portfolio and to loss given default as well as default probability. Their weaknesses are subjectivity, pressure from relationship managers, short data histories and difficulty of validation, especially for low-default portfolios. Banks therefore map internal grades to external ratings to borrow agency default statistics. The exam point is that the two are complements, and each strength of one is a weakness of the other.
A practice question
Which is an advantage of internal ratings over external agency ratings for a commercial bank?
- They are produced by an independent party with no relationship to the borrower.Why not: Independence is an advantage of external ratings; internal ratings are produced by the lender.
- They can cover private companies and small borrowers that agencies do not rate. - correct
- They allow direct comparison of credit quality across different banks.Why not: Comparability across institutions favours external ratings; internal scales differ between banks.
- They have long published default histories covering many decades.Why not: Long public default histories belong to agency ratings; internal systems usually have short histories.
Agencies rate mainly large issuers that seek public debt. Internal systems fill the gap for unrated borrowers and use relationship information.
A harder one
A bank lends mainly to mid-sized private manufacturers, few of which have an agency rating. Which approach is most appropriate for rating these borrowers?
- Build an internal system from financial statements, account history and judgement, validated against defaults. - correct
- Assign every unrated borrower the median agency rating of listed manufacturers.Why not: Ignores borrower-specific information and treats very different private firms as identical.
- Use only the agency ratings of the borrowers' largest customers.Why not: A customer's rating says little about the borrower's own default risk.
- Leave the borrowers unrated and price all loans at the same spread.Why not: Fails to rank-order risk, so risks are mispriced; the bank would lend too much to weak borrowers.
Agency ratings do not cover most private mid-sized firms, so internal ratings built on the bank's own data are needed.
The hardest tier
A bank's relationship manager notes that a borrower lost its largest customer last week. The external agency rating, last reviewed eight months ago, is unchanged. Which statement is the most accurate?
- The agency rating is better because it already reflects all news, and internal ratings should be frozen until the next review.Why not: Agency ratings can lag fresh news, and freezing internal ratings discards a timely signal.
- Internal ratings are superior in every respect, so the bank can disregard external ratings altogether.Why not: Ignores the independence, comparability and long history of external ratings; the two are complements.
- Neither rating can change before the next scheduled agency review, so the bank must wait.Why not: Incorrect: internal systems can be updated at once, and agencies can also act between scheduled reviews.
- The internal rating can capture the news quickly while the agency rating may lag, but officers may rate generously. - correct
Internal ratings can react quickly because they use current private information, whereas agency ratings are slow-moving. Internal ratings carry a risk of bias from officers with an incentive to keep loans looking sound, so independent review matters.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in External and Internal Credit Ratings
- Describe the scales used by external rating agencies, how ratings are assigned, and how a rating connects to the chance of default.
- Distinguish default probabilities that are conditional from those that are unconditional, defining each.
- Define the hazard rate, then apply it to find the unconditional probability that a credit asset defaults.
- Define the recovery rate and, with it, compute the loan's expected loss.
- Contrast ratings built on a point-in-time basis with those built through the cycle, and explain each.
- Outline the options that can be used in place of the credit ratings issued by rating agencies.
- Describe a rating transition matrix, calculate with it, interpret it, and explain what it is used for.
- Outline how credit default swap spreads, bond prices and stock prices tend to move when a credit rating is upgraded or downgraded.
- Explain where credit ratings have failed in the past and what difficulties arise when they are relied on for investment decisions.