Intercompany Credit Ratings Modelling Summary
An intercompany credit ratings model is a model that assesses the credit rating of intercompany subsidiaries. It is convenient to have such a model as it will objectively assess the risk and as such the price (margin) that needs to be put into intercompany agreements.
It mostly takes away discussions with individual subsidiaries because the mechanism is embedded in a group wide pricing policy. On top of that a model allows for automation and therefor reduces chances of errors in intercompany prices and reduces workload. Frequent updating of prices is no more a hassle.
And last but not least the intercompany credit ratings model is based on market practices. This ensures the resulting prices to be at arm’s length and being compliant with the OECD guidelines.
What is Intercompany Credit Ratings Modelling?
Intercompany credit ratings modelling is a useful tool to correctly price intercompany contracts. All transactions occurring between subsidiaries within a group for which a contract exists that has risk based pricing components are in scope. Examples of such contracts are current accounts, loans and factoring agreements. In these examples the risk component is credit risk which is the base for price setting.
A correct pricing of intercompany contracts means that the so-called arm’s length principle is adhered to. Arm’s length pricing is a transfer pricing topic and in many cases these are used intermixed. Arm’s length pricing is to be understood as the price that is agreed upon on intercompany agreements is the same price as would be agreed upon between comparable unrelated parties (“CUP analysis”). If for example a given subsidiary in a group would borrow money from a bank then the price – the interest rate – is determined by the bank in combination with negotiating power of the subsidiary. An at arm’s length pricing is achieved when the subsidiary pays an equally same interest to the intercompany party as it would to the bank.
The easiest way of pricing intercompany agreements is then to obtain comparable pricing in the external market. The subsidiary would then have to go through the information supply to a number of banks and obtain prices. This price range is then used to set a price on the intercompany agreement.
However banks or other financial institutions are not very much inclined to go through the hassle of pricing an agreement only with the purpose of providing a price. The lending institution wants to gain the business for real. It is for this reason that pricing based on obtaining direct pricing from external parties is not often a useful practice.
How then to price intercompany agreements? And moreover, how to set the right price?
A bank generally prices agreements with various components, such as:
- Base rate
- Fee structures
The base rate is basically the risk free rate of the currency in which the agreement is denominated. Benchmark rates are often used like EURIBOR or LIBOR. In the latter case more and more alternatives are becoming available following the LIBOR scandals that have taken place in the last few years.
The base rates should be obtained for the same time period as the interest rate setting is contractually agreed upon. If the interest in the agreement is set at 3 months variable then also the 3 months base rate should be used.
The margin is a risk determined rate. Essentially the bank undertakes a risk assessment of the company to which it intends to lend money. The risk assessment can be expressed in a rating. Each rating has a scale of margin associated which is the price. In corporate environments a price scale can be constructed using loan or bond market data available from suppliers like Reuters and Bloomberg.
Fee structures exist for many various variants in terms and conditions. Common examples are commitment fees, annual fees etcetera. These typically cover the pricing of certain conditions in the agreement. For example if a revolving credit facility or a bank overdraft is committed the bank needs to make cost to ensure the full capital is available at all times. These costs are charged through with a commitment fee.
In this article we will focus on the model to assess the margin – the risk assessment of the borrowing company. The final price for a subsidiary is based on a combination of the model’s rating output for a subsidiary and the benchmark price grid. Note that in this example the choice has been made to not apply negative interest base rates. Of course this needs to be reflected in the agreements.
Each risk can be assessed by using a combination of qualitative and quantitative analysis.
Quantitative risk analysis is based on facts and figures and can be modelled. A qualitative analysis is a subjective assessment of an organization. The outcome of a subjective assessment can alter depending on the person or persons conducting the analysis and the persons interviewed.
Rating agencies like Standard & Poors and Moody’s have a large number of staff that undertake qualitative analysis. They conduct interviews with management and critical staff members. These interviews result in a SWOT analysis (Strenghts, Weaknesses, Opportunities and Threats). The results of these are a base for assessing the strategic direction of an organization and how well it is accustomed to changing environments. Because qualitative analyses are subjective to changing environments and interpretations of the interviewers, a qualitative analysis is less suitable for intercompany pricing. Also because of the bias of the interviewers being from the company itself it makes qualitative analysis unfit to use for intercompany pricing.
Quantitative risk analysis however is based on facts and figures. The outcome is factual and the results are usable for intercompany pricing. This analysis aims to get an assessment about the financial strength of the company and looks at balance sheet, income statement and cash flow statement. These are both historic looking and when available in the organization forward looking as well.
In the internal rating model choices need to be made on those items where qualitative risk assessment is used. Each of the choices made needs to be documented in the internal pricing policy.
The internal rating model
The ratings model as provided here is Standard & Poors’ Corporate Ratings Methodology. It consists of a number of steps which are all being input in the model to arrive at the issuer credit rating.
It starts with the Business Risk profile and the Financial Risk profile to arrive at the Anchor.
The Anchor is the first rating that is available. This rating can be notched up or down should the Modifiers justify so. After this step the Stand Alone Credit Profile is available. For each subsidiary the Group Influence will be assessed to arrive at the Issuer Credit Rating.
For those organizations that want to price individual issuances another step is made which is the Debt Instrument Analysis to arrive at the Issue Rating. This is a rating specifically for a single issuance. This can be useful if there is for example an internal bond placed to a large subsidiary.
Limitations of the model for internal use
In corporate environments not all inputs can be objectively delivered by the corporate itself. Therefor it is required to make choices when constructing an internal model. For example competitive position (part of the Business Risk profile assessment) consists of:
- competitive advantages
- scale, scope and diversity
- operating efficiency
Of these, only profitability is a measure which can be objectively measured based on facts and figures. The other three are subjective measurements in a qualitative assessment. In the internal model only profitability is then used. At the same time the reasoning is then input into the policy that due to the subjective nature only profitability is made part of the ratings model.
Making reasoned choices when setting up the model and defining those in the underlying pricing policy is what makes the model robust and usable for internal pricing purposes.
Once the model is live there is a companywide pricing mechanism that is in sync with common market practices. The prices therefor are at arm’s length. Each subsidiary gets treated the same based on its performance in the group. By having all of the choices documented in the pricing policy it is ensured that knowledge is kept in reach.
Building the model ensures that it can be run in real-time which means that frequent updating of variable interest rates for intercompany contracts is possible without excessive resource consumption.