Public sector: getting to grips with credit ratings is worth it
Credit ratings are becoming more common in the public sector. A credit rating is a report on the financial health of a company or institution. However, directors and finance managers often regard the rating process as a bit of a mystery. As far as Zanders consultants Charles Zondag and Hendrik Pons are concerned, it is certainly worth getting to grips with the dynamics of credit ratings.
Like the private sector, the public sector is also increasingly faced with higher (or much higher) margins on bank loans. This is due to weak or weaker key financial ratios, greater operation of market forces, a withdrawing government, and minimal liquidity in the financial markets. The impact of these factors on credit margins is a relatively new and unfamiliar phenomenon for the public sector. One of the key drivers in deciding about credit margins is the credit report, which the bank prepares (internally) when assessing its counterparty risk. But how is the credit rating worked out? What aspects of the process can be infl uenced, and how? Experiences from the corporate sector show that insight in the calculation of the credit report can provide significant value for directors and finance managers.
Spoilt with low credit margins
Before the banking and debt crisis, the cost of funding within the public sectors was largely dependent on the banks’ commercial interests and objectives. Anticipating expected but slow changes in the healthcare sector (market operations) and the social housing sector (separation of public and private), the banks tried to gain market share by providing finance at or even below the internal cost price (cost of funding). Banks spoiled public institutions with very low credit margins. Key financial ratios and collateral were often subordinated to the higher goal.
More stringent banking regulations (Basel III) are now forcing banks to set aside more capital, and capital of higher quality, to cover the usual banking risks. The banks also have to comply with very strict standards in terms of the liquidity and funding of their balance sheets. This means that, for the same amount of capital, a bank will have to accept a lower business volume, which may result in a smaller credit portfolio. Because the capital still has to achieve market-based returns to satisfy the banks’ shareholders, the banks will have to raise more revenues (in relative terms) from the lower business volume. This will imply higher credit margins and potential other charges (or fees).
Credit rating process a black box
The credit margin is determined to a large extent by the borrower’s risk profi le. The bank will determine this risk profi le on the basis of three components:
- the risk related to the debtor (often referred to as counterparty risk)
- the risk related to the loan type and the loan term
- the risk related to the collateral structure
The rating process as part of the risk profi ling in particular is regarded by directors as a black box. Instead, directors and finance managers in the public sector are looking for transparency. They have a growing desire to understand and control the dynamics of their own credit rating, in order to positively infl uence the cost of funding directly and indirectly. Understanding how their credit rating comes about will also give directors and managers an opportunity to assess the impact of strategic choices that affect the credit rating.
Review provides insight
Regular reviews of the credit rating, conducted independently of the banks, provide the desired insight. They also off er insight into the financial health of the institution in relation to similar institutions. Such insights can be elaborated at an abstract level (such as a credit rating), but also at a detailed level, for instance resulting in a comparison of elements such as ‘operational developments’ and ‘capital structure’.
An understanding of the dynamics of credit ratings makes directors familiar with the subject matter and allows them to seek independent advice on an appropriate credit margin for the institution’s borrowing.