Applicability of rating models to credit demand evaluations under basel II framework

ABSTRACTDevelopment of sophisticated and accurate credit rating models isessential given the influence such ratings can have on the decision makingprocess of the banks. Early detection of low quality borrowers helps bankscontrol the amount of bad loans on their credit portfolio. Given the importanceof the subject, BIS (Bank for International Settlements) have provided crucialguidelines for the banks that aim to develop their own models. Purpose ofthis study is to provide a summary of different credit rating models that canbe implemented in compliance with Basel II.In Part 1, a general definition of credit rating is provided. Alsodevelopment of various models, and their differences are covered. Worldknown credit rating firms, their organizational structures, and methodologiesthey use are summarized.Basel I and Basel II accords are the subject of Part 2. These accordshave profound implications on some practices within the financial institutions.In order to implement credit risk models for quantifying banks? exposure tocredit risk, a healthy credit rating models is a must. Thus Basel II provides,somewhat general, guidelines on how to accurately measure the creditworthiness of potential borrowers. Given the fact that most of Turkey?s realsector is alien to such concepts, implementation of Basel II is going to have aprofound impact on Turkish economy.In Part 3, a literature survey on credit rating modeling is provided.Various methodologies and recent research are covered in detail. In the lastsection, I propose a new model that I have found to be quite accurate basedon the data I have collected. A simple exercise of this model on amanufacturing firm is also provided.