What happens if external credit ratings are not available?
How can a bank estimate the creditworthiness of a counterparty if no “AAA, BBa or CCC” is given?
This is indeed a rather common problem.The ratings that are published by rating agencies are in fact only available for relatively large companies, those companies issuing publicly traded bonds. This is clearly not the case of many SMEs.

A similar reasoning holds for people. Moody’s, Fitch and Standard & Poor’s are not going to assign a rating to any of us. So how does bank decide about the reliability of people asking for mortgages?

In all these cases, banks can rely on internal-rating methods.
For people, we have tools like the FICO score, which we are not going to cover here, for the moment.
For companies, there are many different possibilities. One of the most important one is represented by financial distress indices, based on discriminant analysis. In this lecture we will consider the propotype of this class of tools: the famous Altman’s Z-score.
We will see how the Z-score is computed and how it is actually used.

Finally, we will briefly discuss recovery rates, because in the event of a default we typically do not lose everything. Hopefully…

Here you can find the slides of this class. Here the script.