Notching

Notching means a practical activity of credit reference agencies to assign various credit ratings to the specific liabilities of one issuing institution or other associated organizations. The priority of claims for liabilities defines their rating variety. Notably, in case of a default, the obligations are rated higher or lower. For instance, the enterprise possesses a credit rating of “BB”, although, in some circumstances, its subordinated debt is notched only as “B”. 

Working principle of Notching

In fact, credit rating agencies tend to estimate a business solvency of the companies, as well as their capacity to render the debt payments or liabilities. Moody’s, S&P, along with Fitch Ratings are considered the largest rating corporations in the world.  

Data, collected by the groups, serve as a target for predicting the capital bankruptcy, and bringing subsequently a certain return. These agencies show the notching up or notching down of the firms.

Nevertheless, the enterprise is able to issue multiple obligations (secured or not), as well as linked liabilities (non-participating shares, or exchangeable bonds). As a consequence, the credit rating for these specific debts can be distinct from the firm’s general one. Particular risks and liabilities limits are also taken into account. 

Debts have two facets. Initially, the obligations express a default probability, that is based on financial ratios. In the next place, there are the liabilities that demonstrate a recovery ratio after this default.

In other words, the key procedures for notching tools can be called:

• a corporate family rating (CFR);
• a debenture debt of the borrower. 

Moody’s renovated manual for Notching

First of all, it should be noted that the base is called the first unfunded liability of the obligor or the CFR. It is also known as base=0. 

So, moving back to the half of decade ago, one of the credit rating agencies released the guiding principles, dedicated to notching. 

The ground rules of Moody’s include:

1. Superior secured obligation: +1 or +2 notches presented above the base.
2. Superior unfunded liability: 0.
3. Junior debt: -1 or -2.
4. Inferior junior debt: -1 or -2.
5. Privileged share: -2.

There is no doubt that there are instances, when the mentioned bound violation happens. For example, for +2 or -2. 

It is possible, only if the following conditions are met:

• The additional complexity in a legal framework of the enterprise is at play.
• The unbalanced composition of capital leads to a certain liability making up a small or major fraction of joint debt.
• The legal regulation should be less foreseeable. 

Notching in real life

The notching practice can be used in debt ratings, which are issued by subsidiaries and controlling companies. 

In certain cases, the debts of an affiliated company may be much higher than the liabilities of a parent enterprise. The reason for this fact lies in the holding that possesses the assets and monetary flows of the whole structure. 

Usually, the notching guidelines are applied to a rating composition that is suitable for all sectors. The only exception refers to the situations of increased losses, so that they proceed beyond the realm. 

The notching process touches upon a banking system, reinsurance companies, as well as non-financial corporations.