The link between credit scoring and credit rating

It may seem obvious when you reflect on it, but credit scoring and credit rating are the subject of confusion and controversy. Used properly, they are great tools in credit provision and pricing.

Credit reference bureaus (CRBs) are licensed by the Central Bank to provide a platform for credit information sharing by regulated financial institutions, including banks, micro-finance institutions and saccos.

The CRBs use the data to generate credit scores. We use credit scores to get a probability of default when lending to individuals. Combined with loss in case of default, we can calculate and therefore accurately price the expected loss in any individual lending. This is what the Central Bank of Kenya is demanding that Kenyan banks do with risk-based pricing of loans.

So far, CBK has approved 30 risk-based pricing models. In this approach, nobody should ever be denied credit. What should change is the pricing of the credit, with riskier customers paying higher interest rates.

Creditworthiness

Since those individuals work in companies, we should get a company credit rating to give us an idea of the creditworthiness of the companies themselves. Such an understanding will strengthen personal loan products.

For instance, many salary-based loans go bad when employers are struggling to pay salaries or have closed.

The fortunes of a particular firm are tied to the trends in the industry they belong to. Which implies we should have a clear idea about the industry in which the company is operating. We can achieve that via industry reports.

Companies often work from a particular location, so it makes sense to get a county rating, and ultimately a country or sovereign credit rating.

Individual credit scores are built by observing verifiable behavioural data such as regularity or frequency of payments, timeliness of payments and so on.

The 360-degree view of the person is formed using data from various sources, particularly from credit information sharing, utilities and so on.

Credit rating follows an assessment framework using historical financial performance data, strategy or business plan information, and industry comparison. The assessment will examine the strength of the management team, and perform a risk analysis.

The creditworthiness of a company is expressed in rather arcane-styled letters such as BB-. The higher ratings are considered investment grade, while lower-rated companies are riskier propositions.

Financial institutions providing credit to corporates, as well as investors, are well advised to use credit ratings. Recently, credit rating entities such as Metropol Corporation have assisted banks extend credit rating to small and medium-sized companies.

Industry and sector reports take an even broader view, analysing many companies that together constitute an industry, and looking at various industries that comprise a sector. Industry analysis gives you insights into standard operating parameters. It provides you a basis to compare a company with peers.

If an industry is on its way out, it is unlikely that individual companies in it are thriving. When digital photos replaced film, the fortunes of Kodak and others who produced camera film soon ran out.

Young people may be surprised to learn that we took photos by exposing the images onto a roll of film, which you then took to a studio for development. With the advent of digital cameras, not only were companies making film out of business, the studios that developed photos had to offer different services to survive.

Infrastructure bond

Although credit rating for cities and municipalities, as well as other sub-sovereigns such as states or counties is relatively common in parts of the world, the rating of Kenya’s counties and cities is quite novel. So far only five counties – Laikipia, Makueni, Kisumu, Bungoma and Nyandarua, have been rated.

Of these, only Laikipia maintained an annual credit rating review and used it to arrange finance, succeeding in financing equipment leasing, while her infrastructure bond has remained stuck in Parliament.

Entities that are providing counties with significant credit, from large construction projects to short-term payroll support, should consider county ratings in decision-making.

Just as with individual credit scores, sovereign or country ratings have a big influence on how countries access loans and the pricing of those loans. Kenya’s rating was recently downgraded by some rating agencies.

Sovereign ratings are dominated by Western rating agencies. This has led to accusations of assessment bias that disadvantages African countries when they issue securities internationally. Some experts believe African countries are paying as much as 1–1.5 per cent more on interest on Eurobonds because of these ratings.

This has prompted calls by the African Union for an African credit rating agency, either as a market-led initiative or a specialised agency of the union. A team within the Africa Peer Review Mechanism has already been producing regular reviews of sovereign credit rating.

Rating agencies are regulated by the capital markets authorities, while credit reference bureaus are regulated by central banks. Kenya has three credit reference bureaus and four rating agencies.

Late last year, some controversy arose out of the misunderstanding of how credit scores are generated as well as their use. Some policymakers had the mistaken notion that CRBs were a hindrance to credit.

And while it was factual that some lenders used the CRB information as a binary yes or no input into their credit decisions, the Central Bank quickly stepped in to enforce risk-based pricing.

A number of banks have this past week announced interest rate hikes. This has nothing to do with risk-based pricing. Rather, banks are using the opportunity of the recent hike in the central bank rate (CBR) to revise their rates upwards. CBK for its part has insisted that interest rates have to be kept high to control inflation!

@NdirituMuriithi is an economist