not to justify the cost of maintaining an additional model. Also, NTSA perceived weaknesses in the methodology, including the reliance on historical volatility of book values. Such reliance would not consider business cycles and structural changes. NTSA’s analytical process is described here for the benefit of a reader considering such an approach for credit risk assessment in their country.

# **iv) Summary of credit risk assessment methodologies and their use by the NTSA**

All three credit risk assessment methodologies discussed in this paper exhibit strengths and weaknesses. NTSA primarily relies on credit rating, uses scenario analysis as a complementary tool, and discontinued using a modified Merton approach.

Credit rating is flexible and intuitive. Scores can be translated into probabilities of distress (PDs) using PD tables (Chapter 2.c.) and credit scores incorporate qualitative information. However, they are mostly based on information from financial statements. Also, using credit ratings and PDs offers limited information on the short‐term impact of credit events on the fiscus.<sup>21</sup> The use of corporate plans as part of the analysis enables a forward‐looking approach to be incorporated into the assessment. In South Africa, credit rating is used to assess Eskom’s ability to service guaranteed debt (see risk management tools chapter below). When rating Eskom, NTSA undertakes a stand‐alone rating, not factoring in potential implicit government support. Rating agencies, however, sometimes notch entities’ ratings upward if they perceive strong government support.

Scenario analysis allows to estimate the potential impact on the fiscus for a relatively short time period,<sup>22</sup> and is used forward looking, incorporating corporate plans. On the other hand, results from scenario analysis cannot be easily translated into PDs<sup>23</sup> and the models require more time and capacity to develop and maintain.

A modified Merton model can capture an intuitive and well‐known theoretical concept and it is easy to apply. However, the results may be questioned in the absence of trading in Eskom’s stock and the reliance on infrequent book values.

# **c) Risk quantification**

Historically, NTSA performed limited risk quantification. Credit ratings allow for a ranking of SOCs assessed (i.e. an SOC rated 8 is less creditworthy than an SOC rated 7). However, the Credit Risk Directorate at NTSA is in a process to improve risk quantification using insights from risk assessment as described above. Improved risk quantification will improve reporting and help in the design of risk

> 21 Credit rating is used to derive probabilities of distress. They focus on the likelihood rather than the severity of a credit event. Also, probabilities of distress may only be expected to converge towards observed distress frequencies in sufficiently large and well diversified portfolios, or over the long term. In the short term (e.g. the budget period), observed default frequencies may be significantly different from estimated PDs due to the small number of beneficiaries in the guarantee portfolio of NTSA and the potential correlation among them.

> 22 In South Africa, budget projections are conducted for a three-year period.

> 23 Unless stochastic modeling was used and probability distributions and correlations among scenario parameters were estimated.

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