Capital MarketsRisk Management

Don’t Ignore the Halo Effect in Credit Ratings for Subsidiaries

By December 20, 2023No Comments

Why ratings used to set rates for intercompany loans should factor in ‘ordinary’ support parents provide subsidiaries.

The internal credit ratings of subsidiaries that a parent company may use to help determine the interest rate for an intercompany loan need to reflect a halo effect that incorporates any day-to-day, ordinary support the subsidiary receives from the parent. That is among the key takeaways from a presentation by Societe Generale at a recent meeting of NeuGroup for Mega-Cap Assistant Treasurers sponsored by the bank.

  • Jacques Ouazana, head of US ratings advisory at Societe Generale, shared recommendations for corporates that want to provide tax authorities with a “fair, consistent, clear and traceable methodological framework” if and when they are asked to explain interest rates based on internal ratings.
  • Societe Generale prepared a methodology for a client with more than 300 subsidiaries across the globe. A banker who worked with the client said that by the end of the process, the company “could show the tax authorities they had, in fact, risk-rated for the country risk and risk-rated for the individual subsidiary.”

Why it matters. One NeuGroup member explaining the significance of credit ratings for subsidiaries noted that the issue lends itself to tax disputes. That’s because interest expense is deductible for corporates, with limits, in most jurisdictions. “Given that interest is deductible and ratings impact credit spreads, the rating matters,” he said. That’s especially true for corporates today given the sharp jump in rates that began in 2022.

  • “One major item of controversy is whether a subsidiary can have a rating different than its ultimate parent company,” the member added. “Many countries argue that the subsidiary benefits from an implicit guarantee from the parent and therefore should be issued the same rating, regardless of sovereign or other risks.”
  • Mr. Ouazana commented, “Making a distinction between only implicit and fully explicit support is necessary from a credit risk perspective—and also justifies why formal guarantees exist. At the end of the day, it is about assessing the likelihood that parent support will be there when needed.”

Ordinary vs. extraordinary. Determining an accurate credit rating for an individual subsidiary requires considering the impact of it being part of a broader group, according to Societe Generale. This includes brand recognition, access to ongoing liquidity as well as use of the group’s technology systems. These benefits constitute what the bank described as a halo effect provided by the parent and are forms of ordinary support.

  • Rating a subsidiary as a standalone entity would not account for the halo effect provided by ordinary support and could lead to pricing a loan at a rate that’s too high. “We need to think about what really differentiates a subsidiary from a standalone entity,” Mr. Ouazana said.
  • By contrast, the bank’s methodology excludes extraordinary support, defined as the parent stepping in to avoid a default on the subsidiary’s debt obligations. As one member noted, most intercompany loans are not guaranteed by the parent.
  • By equalizing the subsidiary’s rating with that of the parent, the latter would become the reference point to price intercompany loans, which could underestimate pricing, according to Societe Generale. In other words, incorporating unguaranteed extraordinary support could mean a loan is priced at a rate that is too low.

Middle ground. Societe Generale’s solution reaches a middle ground that is inspired by rating agency methodologies which are “adapted to fit the unique characteristics of a subsidiary and the need to incorporate some form of support,” Mr. Ouazana told NeuGroup Insights in a follow-up email exchange.

  • “Based on our methodology, we assign to subsidiaries arm’s length credit ratings, which are neither fully supported ratings nor fully standalone ratings,” he said. “They reflect both standalone credit features and some ongoing support provided by the parent.”
  • He added “Because our arm’s length ratings do not reflect full, extraordinary support, they tend to be lower than the parent rating. Overall, we believe that they are a better representation of the individual creditworthiness of a subsidiary.”
Justin Jones

Author Justin Jones

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