may include financial information, the assessment of business risks such as regulatory environment, competitive environment, and management quality.

When entering a guarantee/on-lending agreement risk managers should define information to be collected and assessed in the future. Risk managers may also want to explore third party and market information on beneficiaries and the sectors they operate. Third party information may include risk assessment by banks, rating agencies, or credit bureaus. Market information may include prices of traded debt and equity as well as credit derivatives (e.g. credit default swaps (CDS)).

However, governments should recognize that market conditions pertaining to beneficiaries and potential beneficiaries might reflect perceptions of implicit government support. Furthermore, the provision of a guarantee/on-lending may change the perceived implicit guarantee by market participants. In such cases, market prices would not accurately reflect risk, and risk managers may instead need to rely on market data from proxies with risk characteristics similar to the stand-alone<sup>13</sup> ~~r~~ isk of the beneficiary.

## **_Resources and capacity_**

Sovereign risk managers need to invest in capacity and resources to implement a sound risk management framework. Different approaches to risk analysis and measurement require different skills. For example, fundamental risk analysis (e.g. credit scoring) requires an understanding of industries and their respective risk drivers. Governments should model their risk management framework around available capabilities and financial resources, and adapt the framework over time as capacities improve through training, hiring of new staff, and support from external consultants.

# **2.2 Credit risk analysis**

Assessing the credit quality of entities benefitting from credit guarantees and on-lending is a core part of a risk management framework. First, risk managers need to understand what industry-specific factors are driving the risk of beneficiaries not servicing their debt obligations. Second, risk managers have to assess these risk drivers by beneficiary and on a regular basis.<sup>14</sup> Governments can choose from a variety of approaches to credit risk analysis and tailor them to specific situations.<sup>15</sup> The most common approaches include credit scoring, statistical models, scenario analysis, and structural models, which are discussed below.

## **_Credit scoring_**

Credit scoring involves scoring and aggregating individual risk factors to arrive at an ordinal risk rating for an entity that is compared against other entities. Industry-specific scorecards can be used to guide credit analysts in their assessments, as exemplified in Table 2.1.

Rating agencies and financial institutions often apply credit scoring towards risk assessment.<sup>16</sup> Financial institutions can also base risk analyses on an internal ratings-based (IRB) approach, as outlined by The

> 13 Refers to credit risk of beneficiary without implicit government support. For example, rating agencies sometimes provide stand-alone ratings.

> 14 Risk analysis should be undertaken before guarantees are issued or funds are on-lent and on a regular basis for risk monitoring.

> 15 This decision will depend on the size and complexity of the guarantee portfolio and available resources.

> 16 Rating agencies publish a significant amount of literature explaining their credit risk assessments. The three major rating agencies include Standard & Poor’s, Moody’s Investor Service, and Fitch.

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