An Alternative to the Standardized Approach for Assessing Credit Risk under the Basel Accord

The current standardized approach for assessing credit risk under Basel III depends on the ratings assigned by credit rating agencies (CRAs). This approach presents three problems. First, definitions of ratings of CRAs on assessing the likelihood of default and recovery rates are not uniform. Second, because CRAs assign the rating according TTC (through-the-cycle) ratings, the ratings of CRAs less accurate in predicting short term defaults and react slowly to credit events. Third, there are not many companies whose rating are assigned by CRAs in Japan. To improve the standardized approach under Basel III, we propose a new method to evaluate credit risk without CRAs. We analyze how companies' financial and non-financial attributes affect default and construct a default prediction model using the annual reports of companies listed on the TSE (Tokyo Stock Exchange) from fiscal 2003 to fiscal 2009. Furthermore, using this model, we construct new scoring and rating model. The results indicate that our rating anticipates the likelihood of default at least as accurately as the ratings by CRAs