RATING MEDIUM-SIZED ENTERPRISES – RECENT DEVELOPMENTS
Thomas Link, Prof. Dr. Svetlozar Rachev, Stefan Trück
University of Karlsruhe, Germany
Abstract. In contrast to the situation in the United States, rather weak tendencies towards an infrastructure for external ratings by independent agencies have been observed in Europe in recent decades. Despite a change in this structure due to a new framework for bank's capital adequacy, our paper shows that, especially for middle-class enterprises, thus far there has been no possibility of obtaining an objective rating. The reason is, that information is very asymmetric between investors and capital demands on small and medium-sized companies. A rating which would remove this asymmetry, is not offered by the traditional rating agencies. In our study, not only will we examine the need for the rating of medium-sized companies, but we will also give an overview of characteristics that have to be incorporated in models pricing the debt of such companies. We will also show why so far the traditional models for evaluating default risk have to be adapted to medium sized companies and further describe models, products and companies in this sector and suggest ideas for model refinements.
Key-words: Rating, Credit Risk, Medium-Sized Companies, Risk Weights, Rating Agencies, Spread, Reduced Form Models, Structural Models, Rating Criteria, Discrete-Time Markovian Model, Brownian Motion, Black-Scholes
1) Introduction
1.1) Rating Culture in Germany
Compared to the situation in the United States rather weak tendencies towards an infrastructure for external ratings by independent agencies have been observed in Germany in the last decades. So, according to a study, published by the IWK, Munich, in January 2000 only 170 German enterprises and banks exhibited a rating by an international agency, in the USA about 8000 companies had a rating.[2] Certainly, German banks do internal ratings to decide about whether a company fulfills the requirements to get a credit, but their outcome is not published and often influenced by subjective goals of the respective bank. “Even the firm being rated is typically not informed about its current internal rating”[3]. In contrast to those, external ratings usually are created explicitly in order to publish them and to give a neutral and objective evaluation of a company’s credit status and additionally should give an outlook on its future potential and chances on the market.[4]
What are the reasons for this exceptional difference in the amount of rated companies? One cause can be identified in the typical German house bank system: The bank plays the role of an intermediary between investors and credit demand and gives bank credits to its customers to conditions, which are determined by their internal rating. In the Anglo-Saxon bank system, investment banks are not allowed to issue bonds themselves and, therefore, deal with loans thrown on the market by companies which have a demand for debt financing.[5] This private issuing makes it necessary for those companies to prove their general ability to pay to the public, which can be achieved by a rating created by an acknowledged agency. Another reason is that the demand for industrial loans is much smaller in Germany, because of the broad supply of government bonds and the investors’ rather risk averse attitude. These facts lead to a totally different debt structure in Germany compared to the USA. In Germany nearly half of the debt market is covered by bank credits, in the USA about 80 percent of the market volume for debt are corporate loans.[6]
Recent developments on the international capital markets in the EU obviously are leading to a change of this structure. First, the improvements in the information technology sector and the introduction of the Euro lead to a globalization of the capital markets and bear new possibilities for the provision of capital by issuing industrial loans. Second, the “new framework for banks’ capital adequacy (proposed by) ... the Basle committee on banking supervision (at July,3 1999), intends to reward their portfolios on their aggregate credit rating”[7]. So, banks are induced to evaluate their credit risk by a standardized rating or use external ratings by External Credit Assessment Institutions (ECAI), to categorize it and to back it with equity corresponding to its risk classification.
According to the latest Consultative Document (January 2001) of the Basle Committee the capital requirements for the banks will be higher for loans credits given to unrated companies. This is due to the higher risk weight assigned to unrated corporations entering the capital requirement calculation.
This makes it inevitable, for companies with a strong demand for capital to acceptable conditions, to get rated, as otherwise banks don’t have a clue about the company’s standing and have to conduct a time consuming internal rating process or just give them bad credit conditions. These facts indicate that industry loans as well as ratings are gaining importance on the European capital markets.
This trend, however, causes problems especially for middle-class enterprises, as information is very asymmetric between investors and capital demanding small and medium-sized companies[8] and a rating, which would remove this asymmetry, is not offered by the traditional rating agencies as Standard & Poors, Moody’s or Fitch IBCA for this category of firms[9]. For smaller companies both non-rated and not listed on the stock market the so-far most commonly used models couldn't be applied anyway. Neither the structural approach by Merton and its refinements - e.g. by KMV – nor the reduced form approaches using the rating of a company as an input variable can be used for medium-sized companies since they are not listed on the stock market and do not have a rating. We will show that, especially for middle-class enterprises, thus far there has been no possibility of obtaining an objective rating.
Furthermore, it even might not meet their requirements, because these agencies are specialized mainly on rating bonds and loans, while middle-class companies often are in need of equity capital. Bigger, rated companies, e.g. such listed at the Frankfurt Stock Exchange, saturate their demand for equity on the stock market and naturally spread more information about the firm’s projects and its credit status, which leads to lower capital costs for them, if their prospects are good. On the other hand, medium-sized companies which are not as well-known get worse conditions even if their ability to pay and projects promise prosper future developments, just because of a lack of information on the capital markets. Recognizing this “niche for an agency rating medium-sized companies”[10] several rating agencies for this market sector were established in Germany in 1998. These were the first activities towards a supply of rating products for medium-sized companies in the world.
1.2) Objective of the Paper
This work shall explain why there is a need for a rating for medium-sized companies and describe the problems one might face applying the traditional approached to evaluating Credit Risk. We will further give a brief overview of already existing companies and products for this sector and, furthermore, come up with necessary future steps which have to be taken.
The next chapter shows the consequences of the new Basel Capital Accord (Basel II), the functions a rating for middle-class enterprises has to fulfill, Furthermore, advantages of the existence of middle-class ratings and an exemplary rating process are shown.
In the third chapter we will then have a look at the traditional approaches to estimate default and downgrade risk of companies and make suggestions how they could be applied to Medium Sized Companied.
In the fourth chapter we will then introduce some of the new rating agencies, give information about their target groups and methods. We will also point out the difference to traditional ratings offered by the older agencies. Finally, some further theoretical approaches which might be realized in the future are explained.
The paper ends with a short conclusion of its contents and results.
2) The Need for Rating Products and Refined Credit Risk Models for Medium-sized Enterprises
2.1) The Effect of The New Basel Capital Accord
Due to the New Basel Capital Accord (Basel II)[11] until 2004 every European Bank is obliged to provide approaches in their Internal Rating Systems "which are more comprehensive and sensitive to risks" (Basel II). The new framework – a revision of the 1988 Basel Accord - is due to the problems arising from evaluating new complex instruments in the credit sector and a change in the optimistic view on Credit Risk Modeling as a result of e.g. the Asian Crisis. The capital adequacy can be measured by different methods including external and internal ratings.
The new framework requests banks to evaluate their credit risk by a standardized rating or use external ratings by External Credit Assessment Institutions (ECAI). Further the banks are obliged to categorize the risk and to back it with equity corresponding to its risk classification.
Table 1 shows that according to the latest Consultative Document (January 2001) of the Basle Committee the capital requirements for the banks will be higher for loans credits given to unrated companies than for companies with a rating better than BB-. This is due to the higher risk weight assigned to unrated corporations entering the capital requirement calculation.
(Corporate) Credit Assessment / AAA to AA- / A+ to A- / BBB+ to BB- / Below BB- / UnratedRisk Weights / 20% / 50% / 50% / 150% / 100%*
Figure 1: Risk Weights for Corporates According to the Consultative Document of the Basel Committee of Banking Supervision (January 2001)
Therefore, especially smaller banks dealing with medium sized companies will have to revise their rating system and may be forced to provide higher capital requirements to meet the obligations. The problem is not only that many smaller banks so far didn't have an adequate internal rating system but that at the current state of discussion the revised accord may even not allow for the most commonly used models like KMV or S&P's CreditMetrics. For smaller companies both non-rated and not listed on the stock market the so-far most commonly used models cannot be applied. Neither the structural approach by Merton and its refinements - e.g. by KMV – nor the reduced form approaches using the rating of a company as an input variable can be used for medium-sized companies since they are not listed on the stock market and do not have a rating. We will explain this more thoroughly in the following sections.
The consequence is that the banks will either have to implement a new internal rating system to obtain ratings also for medium sized companies or get these ratings from ECAI (External Credit Assessment Institutions).
Also for companies with demand for capital to acceptable conditions, it is important to get rated, as otherwise banks due to higher capital requirements give them bad credit conditions.
Since not all banks will have an appropriate rating systems or the companies may not be satisfied with their rating given by the housebank there will me more and more need for independent external ratings from ECAIs.
2.2) The Advantages of Ratings for Medium-sized Enterprises
One positive effect of a rating for medium-sized companies certainly is an improvement of the chances of middle-class firms to economically succeed, which recently has been an issue in Germany. This category of companies has been underrepresented and the bankruptcy rate among them too high. A rating in a standardized rating scale (e.g. Moody’s or S&P’s scale) enables an investor without any knowledge of the company and its products to estimate the firms standing and the risk associated with an investment. So, by disclosing the international capital markets for them and, thereby, providing them with better credit conditions and better chances on the stock markets, such a rating system can lead to an improvement of the economical environment for small innovative firms and, in consequence, new industry branches can arise. This is necessary, in order to stay a highly developed country and not to miss the worldwide ongoing economical and industrial change.
Besides this financial aspect, the entrepreneur can extract even more advantageous effects out of a rating. So, he can use it as a means of advertising: The media get information about his company’s success and, thereby, obtain a more positive picture of its products, which is traded on to the customers as well as to suppliers, who are interested in having a successful company as a customer and, therefore, offer better conditions, as for instance discounts. This automatism also works in the field of recruitment; a firm with a rating, that promises a prosper future outlook, will easily attract well-qualified personnel. Another aspect is sales financing. If marketers have a good opinion of the company’s products and their chances on the market, they probably will think about supporting the firm in the marketing sector (see figure 2, p.8).
Another advantage obviously is that investors can choose from a bigger pool of loans and equity titles. The current state in Germany just gives them the opportunity to carry their money to the bank or buy assets of the already listed corporations. If owners of middle-class companies recognize, that by using rating means, they can sell their enterprise to a fair price by going public, more and more of them will take this way of capital funding into account and the number of joint-stock companies will rise.