External ratings in practice · RiskAtoms Academy

By the end you will be able to

1Describe how an agency rates: the issuer-pays model, the committee, issuer and issue ratings, and surveillance.
2Tell outlooks from watches, and read a rating action.
3Map agency scales to each other and to a bank's master scale through default rates.
4Explain the limits of relying on ratings: 2008, cliff effects, and the regulation that followed.

Why it matters

6 of RiskAtoms Bank's twelve corporate borrowers, with 62% of its EAD, sit at investment grade. A downturn that moves each of them down one grade cuts that share to 36% and more than doubles the book's expected loss. Outside the bank, funds that may hold only investment-grade debt would be forced to sell the same names on the same day. Ratings are opinions, but much of the financial system is wired to them.

Core explanation

How agencies rate, and how banks use them

L1.4.07: Credit ratings and credit spreads introduced the agencies and their scales; L3.3.04: Internal ratings and master scales built the bank's own master scale. This lesson connects the two and asks how far a bank should lean on someone else's opinion.

Illustrative dataRiskAtoms Bank plc's credit book

One made-up lending book, in pounds, at one made-up year end: twelve invented corporate borrowers (exposure at default £587m, expected loss £2.81m a year), 152,100 retail accounts in mortgages, personal loans and cards (exposure £4.485bn), a ten-grade master scale and an illustrative rating transition matrix. No firm or person in it is real. The same book runs through every lesson in Module 3.3, so the figures agree from lesson to lesson.

The rating process

ExploreFrom mandate to surveillance

Click a box to see what happens there.

Mandate

Under the issuer-pays model, the company issuing bonds asks and pays for a rating, because many investors will only buy rated debt. The fee creates an obvious conflict of interest, which is why the rules below focus on independence.

Outlooks and watches

Between rating changes, agencies signal direction. An outlook (positive, negative, stable or developing) is a medium-term view, typically six months to two years at S&P. A watch or review is sharper: a change is likely soon, usually because of a specific event, and the agency aims to resolve it within weeks or a few months. Moody's long-term ratings reflect both the chance of default and the expected loss if it happens; S&P's issuer ratings are an opinion of overall creditworthiness, with recovery prospects reflected in issue ratings.

Sort itOutlook, watch or rating action?

“We could lower the rating over the next 12 to 24 months if leverage stays above 4 times.”
“We placed the ratings on review for downgrade after the company agreed a debt-financed acquisition.”
“We lowered the long-term issuer rating to BBB+ from A−.”
“The developing designation reflects uncertainty over the outcome of the litigation.”

Scales and mapping

S&P and Fitch share one scale, with plus and minus signs from AA to CCC; Moody's uses its own letters with numbers 1 to 3 from Aa to Caa. Each step is a notch. The line that matters most is between BBB−/Baa3 and BB+/Ba1, investment grade and high yield.

S&P, Fitch	Moody's	S&P, Fitch	Moody's
AAA	Aaa	BB+	Ba1
AA+	Aa1	BB	Ba2
AA	Aa2	BB−	Ba3
AA−	Aa3	B+	B1
A+	A1	B	B2
A	A2	B−	B3
A−	A3	CCC+	Caa1
BBB+	Baa1	CCC	Caa2
BBB	Baa2	CCC−	Caa3
BBB−	Baa3

Left: investment grade. Right: high yield (CC, C and D below are not shown).

A bank links the agency scale to its master scale with a documented mapping, usually by matching default rates, and uses it two ways: to borrow the agencies' long default histories when its own data are thin (L3.3.06: Probability of default), and to benchmark its own grades against borrowers both have rated.

The formal version

Mapping by default rates

Let $d_r$ be the long-run one-year default rate of agency rating $r$ , and let grade $k$ of the master scale cover $[\underline{p}_k,\ \overline{p}_k)$ . The mapping sends each rating to the grade that contains its default rate:

\begin{aligned} G(r) &= k \quad\text{such that}\quad \underline{p}_k \le d_r < \overline{p}_k \\ d_{\mathrm{BBB}} &= 0.20\% \in [0.20\%,\ 0.40\%) \;\Rightarrow\; G(\mathrm{BBB}) = 4 \end{aligned}

The book's transition matrix supplies illustrative long-run default rates by letter (its default column, studied in L3.3.07: Rating migration):

Rating	1-year default rate	5-year cumulative	Master grade	Grade's central PD
AAA	0.00%	0.10%	1	0.03%
AA	0.02%	0.29%	1	0.03%
A	0.05%	0.77%	2	0.07%
BBB	0.20%	2.86%	4	0.28%
BB	1.00%	9.37%	6	1.13%
B	4.00%	24.78%	8	4.53%
CCC	27.20%	66.45%	10	30.00%

Two cautions. A whole letter spans three notches, so its average default rate can sit on a band edge: A at 0.05% maps to grade 2, while the book's guide column puts A and A−, the weaker notches, in grade 3. And the agency's rate is an average over many years and many issuers; it is a through-the-cycle figure, not this year's (L3.3.06: Probability of default).

Try it

Move the whole book down one grade, then two. Watch which borrowers fall below the investment-grade line, and how much faster expected loss grows than the number of grades.

Try itDowngrade the whole book

Every borrower moves down by1 grade

Borrower	EAD	Grade	Agency-style	Status
Thornvale Engineering Ltd	£52.5m	4 → 5	BBB−	investment grade
Bramwick Stores plc	£76.0m	6 → 7	BB− to B+	high yield
Pellcourt Properties Ltd	£120.0m	5 → 6	BB+ to BB	fallen angel
Ostreth Energie GmbH	£70.0m	3 → 4	BBB+ to BBB	investment grade
Larkhollow Freight Ltd	£29.0m	7 → 8	B	high yield
Mirefield Care Homes Ltd	£44.3m	6 → 7	BB− to B+	high yield
Quorrel Systems BV	£30.0m	5 → 6	BB+ to BB	fallen angel
Hastemoor Construction Ltd	£24.3m	8 → 9	B− to CCC+	high yield
Vellacourt Hôtels SAS	£39.0m	7 → 8	B	high yield
Cindral Pharma Inc	£45.0m	2 → 3	A to A−	investment grade
Graybeck Plastics Ltd	£12.0m	9 → 10	CCC to C	high yield
Sallowmere Logistics GmbH	£45.0m	4 → 5	BBB−	investment grade

Investment-grade EAD£212.5m

Share of the book36.2%

Fallen angels2 (£150.0m)

Expected loss a year£6.59m

Versus today2.34×

Investment grade here means master grades 1 to 5 (grade 5 is the BBB− equivalent). A fund that may hold only investment-grade debt would have to sell every fallen angel, at the same moment as every similar fund.

Worked example

A rating path for Ostreth Energie GmbH

An illustrative scenario: Ostreth Energie GmbH, internal grade 3 (A to A− equivalent), also rated by an agency. The events are invented; the bank's numbers come from the book.

TimelineFrom stable to downgrade, and the bank's response

1 / 5

Month 0

A−, outlook stable

The agency rates Ostreth A−. The bank's grade 3 (PD 0.14%) agrees with its mapping. EL on the bank's £70m EAD: £39.2k a year.

The whole book, one and two grades down

Investment-grade share of EAD: 61.8% today, 36.2% one grade down, 19.6% two grades down. Expected loss: £2.81m, £6.59m, £11.90m. Fallen angels after one grade: Pellcourt Properties Ltd and Quorrel Systems BV (£150m).

Regulatory lens

The 2008 crisis turned rating agencies into regulated firms. In the EU, Regulation (EC) No 1060/2009 requires agencies to register and sets rules on conflicts of interest, methodologies and disclosure; since July 2011 the European Securities and Markets Authority (ESMA) registers and supervises them directly, and amendments in 2013 told financial institutions not to rely solely or mechanistically on external ratings. In the US, section 939A of the Dodd-Frank Act (2010) required federal agencies to remove references to credit ratings from their regulations and substitute their own standards of creditworthiness. The FSB's Principles for Reducing Reliance on CRA Ratings (October 2010) asked the same of standard setters and of firms. External ratings still set risk weights in the Basel standardised approach for credit risk, with due-diligence requirements: that is M4.2: Credit risk capital.

Spark Atoms

Spark AtomInvestment grade until the end

On 28 November 2001 S&P cut Enron to junk, and Moody's and Fitch quickly followed. The downgrade put about $3.9 billion of debt due immediately and Dynegy abandoned its rescue merger. Enron filed for bankruptcy days later. For most of its final collapse, its debt had been rated investment grade.

Spark AtomTriple-A, then junk

The US Financial Crisis Inquiry Commission reported that of the mortgage-backed securities Moody's rated triple-A in 2006, 73% had been downgraded to junk by April 2010. Ratings built on the assumption that house prices would not fall everywhere at once failed together.

Key takeaways

Agencies rate under the issuer-pays model, by committee, with issuer and issue ratings and continuous surveillance.
Outlooks signal medium-term direction (6 to 24 months at S&P); watches and reviews flag a likely near-term change.
Banks map agency ratings to master grades by default rates; whole letters can straddle grades.
Thresholds such as BBB− create cliff effects: forced selling, collateral calls and jumps in EL.
Since 2008: agencies are registered and supervised, and laws push firms to make their own credit assessments.

Reaction

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Glossary

Issuer rating: A rating of the borrower's overall ability and willingness to pay its debts.
Issue rating: A rating of one bond or loan, which can sit above or below the issuer rating because of its security and seniority.
Notch: One step on the rating scale, such as from A to A−, or from A2 to A3 at Moody's.
Outlook: An agency's view of the likely direction of a rating over the medium term: positive, negative, stable or developing. S&P puts the horizon at typically six months to two years.
Watch or review: A signal that a rating may change soon, usually after an event such as a merger: CreditWatch at S&P and Fitch's Rating Watch; Moody's places ratings on review.
Rating committee: The group of analysts that votes on every rating decision; no single analyst can set a rating.
Issuer-pays model: The business model in which the issuer of the debt pays the agency for its rating.
Surveillance: The agency's ongoing monitoring of a rating after it is published.
Fallen angel: A borrower or bond cut from investment grade (BBB− or above) to high yield.
Cliff effect: A large, sudden effect from a small rating change, because rules, contracts or mandates switch at a rating threshold.
Rating mapping: A documented rule linking each agency rating to an internal grade, usually by comparing default rates.
Credit rating agency (CRA): Credit rating agency. In law, a firm whose ratings may be used for regulatory purposes once it is registered or certified.

Deep Dives & Origins

Deep Dives

R. Cantor and F. Packer, “The credit rating industry”, Federal Reserve Bank of New York Quarterly Review 19(2), 1994, pp. 1–26. Introductory.
Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report, US Government Printing Office, 2011, chapter 7. Intermediate.

Origins

Moody's Investors Service, Rating Symbols and Definitions, November 2023.
S&P Global Ratings, S&P Global Ratings Definitions, July 2019.
Regulation (EC) No 1060/2009 of the European Parliament and of the Council on credit rating agencies (EUR-Lex summary).
US Securities and Exchange Commission, Report on Review of Reliance on Credit Ratings (section 939A of the Dodd-Frank Act), July 2011.
Financial Stability Board, Principles for Reducing Reliance on CRA Ratings, 27 October 2010.
CNN Money, “Enron's ratings cut to junk”, 28 November 2001.

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