Credit Rating Philosophy

From Open Risk Manual

Definition

Credit Rating Philosophy denotes the methodologies, policies and criteria used for assigning borrowers (obligors) to the grades of a Credit Rating System

Regulated institutions using credit ratings must choose an appropriate philosophy taking into account all of the following principles[1],[2] :

Assignment of Obligors

  • Institutions should assess whether the method used to quantify the risk parameter is adequate for the rating philosophy and understand the characteristics and dynamics of the assignment of obligors or exposures to grades or pools (‘rating assignment’) and of the risk parameter estimates that result from the method used.
  • Institutions should assess the adequacy of the resulting characteristics and dynamics of the rating assignment and risk parameter estimates that result from the method used, with regard to their various uses and should understand their impact on the dynamics and volatility of own funds requirements.
  • The rating philosophy should also be taken into account for back testing purposes. Philosophies sensitive to economic conditions tend to estimate PDs that are better predictors of each year’s default rates. On the other hand, philosophies less sensitive to economic conditions tend to estimate PDs that are closer to the average PD across the various states of the economy, but that differ from observed default rates in years where the state of the economy is above or below its average. Deviations between observed default rates and the long-run average default rate of the relevant grade will hence be more likely in rating systems less sensitive to economic conditions. In contrast, migrations among grades will be more likely in rating systems which are more sensitive to economic conditions. These patterns should be taken into account when assessing the results of back-testing and, where relevant, benchmarking analysis.


Although the time horizon used in PD estimation is one year the rating/grade/pool assignment process should also adequately anticipate and reflect risk over a longer time horizon and take into account plausible changes in economic conditions. In order to achieve this objective:

  • all relevant information should be included in the rating/grade/pool assignment process, giving an appropriate balance between drivers that are predictive only over a short time horizon and drivers that are predictive over a longer time horizon;
  • a horizon of two to three years is considered to be appropriate for most portfolios;
  • in accounting for plausible changes in economic conditions, the institution should consider at least past observed default patterns;
  • the model should perform under different economic conditions.


As a consequence of the above, institutions’ grade assignment dynamics should also adequately anticipate and reflect in the assignment of grades the potential realisation of the risk during the longer time horizon. For clarity, this does not mean that grades remain stable during the longer time horizon in the event of changes in idiosyncratic risk.

Consistency over Time

Institutions should apply the chosen rating philosophy consistently over time. Institutions should analyse the appropriateness of the philosophy underlying the assignment of obligors or exposures to grades or pools (‘rating philosophy’), taking into account all of the following:

  • design of risk drivers;
  • migration across grades or pools;
  • changes in the yearly default rates of each grade or pool.

Multiple Rating Systems

Where institutions use different rating systems characterised by different rating philosophies, they should use the information on the rating assignments or risk parameters estimates with caution, especially when making use of rating information or default experience obtained from external rating agencies.

Where institutions use different rating systems with different characteristics, such as different philosophies or different levels of objectivity, accuracy, stability, or conservatism, they should ensure that the rating systems have an appropriate level of consistency and that any differences between them are well understood. Such understanding should at least enable the institution to define an appropriate way to combine or aggregate the information produced by the various rating systems when this is necessary according to the institution’s policies.

Institutions should have full understanding of the assumptions and potential inaccuracies arising from such a combination or aggregation.

References

  1. EBA, Guidelines on PD estimation, LGD estimation and the treatment of defaulted exposures, Nov 2017
  2. ECB guide to internal models - Credit Risk, Sep 2018

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