An integrated credit rating and loan quality model: application to bank shipping finance

Abstract

Assessing a borrower’s credit quality is a critical input for efficient bank loan facility allocation, particularly at phases of financial distress. An integrated credit rating model is proposed to borrowers’ credit rating in support of bank financing decisions. Based on a global bank survey, a core set of critical quantitative and qualitative criteria are initially identified and are subsequently weighted and rated, incorporating a dynamic multicriteria optimization approach. The issue of credit rating migration, inducing adjustments in bank financing decisions, is also investigated. The empirical findings can be instrumental to bank credit policy decisions and risk management.

Acknowledgements

The authors would like to thank anonymous bank credit managers that responded to the bank finance credit rating survey and contributed constructive comments to benefit the paper as well as colleagues at the Department of Financial and Management Engineering, University of Aegean for fruitful remarks. Constructive comments by anonymous reviewers that led to the improvement of the paper’s quality are also kindly acknowledged.

Notes

1. The Basel Committee on Banking Supervision operates under the auspice of the Bank for International Settlements (BIS).

2. Basel III has been agreed upon by the BCBS members in 2010–2011 (BCBS 2011), as a global regulatory standard on bank capital adequacy, stress testing and market liquidity risk. Following Basel I and II, Basel III has been developed in response to the deficiencies in financial regulation revealed by the 2008 financial crisis. Basel III introduces new regulatory requirements on bank liquidity and bank leverage and strengthens bank capital requirements. The implementation of Basel III has been extended until March 31, 2018.

3. The BCBS justifies the rationale for adopting this approach on the basis of two primary objectives: (a) risk sensitivity: capital requirements based on internal estimates are more sensitive to the credit risk in a bank’s portfolio of assets; (b) incentive compatibility: banks should adopt better risk management techniques to control for the credit risk in their portfolio in order to minimize regulatory capital.

4. Boyes, Hoffman, and Low (1989) argue that if lenders rely strictly on quantitative credit scores, then sample selection is deterministically governed by applicants’ attributes and the sample selection can lead to biased estimates. A number of lenders maintain that credit scoring is only one aspect of the credit assessment process and that loan managers also incorporate subjective assessments in loan granting decisions.

5. The only exception is the ‘no information’ answer (that appears last in some of the subfields but still does not get the highest score; instead, it gets a weighted average score, as the matrix user does not have any information about this subfield).

6. The 10-position rating system was selected following fruitful feedback from bank credit managers, participants in the bank finance survey. Most bank credit departments in the sample were seen to follow a similar rating system approach.

7. All of these grade scales include ‘+’ and ‘−’ modifiers.

8. The first stage of a shipping cycle (‘trough’) is characterized by excess capacity (Stopford 2009). A number of ships begin to accumulate at trading ports, while others slow down shipments by delaying their arrivals at full ports. Ships still carrying goods also slow down to save on fuel costs. In a trough, freight costs tend to start falling. Freight costs will typically decrease to the equivalent of vessel operating costs. Shipping companies start to experience a negative cash flow which, in turn, prompts the selling of inefficient fleet. Selling prices for ships tend to be lower, with some fleet exchanged at salvage rates (Harwood 2006).

9. As a note of caution, insuperable data limitations are frequently a critical constraint in performing an extensive credit rating and quality analysis in the shipping industry (Lin, Liu, and Chu 2005; Harwood 2006; Grammenos 2010).

10. The deterioration of credit rating does not necessarily imply default of the underlying loan; it does indicate, however, that the PD on this loan has increased (Bessis 2011).