Credit Rating Scale

From Open Risk Manual

Definition

A Credit Rating Scale is a classification framework that helps assign debtors to one of a finite set of rating states, capturing in a simplified way their Creditworthiness. A Rating Scale is one of the key components of a Credit Rating System. It is an ordered sequence of states (markers, labels), where each state assigns to a borrower (/counterparty) or credit product a distinct degree of Credit Risk. A rating scale is an example of specifying a State Space.

Usage

  • A debtor i is (at any timepoint k) assigned (classified) into a rating state R_k^i, taking values in [1,\ldots,D]
  • R_k^i=0 is the best credit quality state
  • R_k^i=D is the worst (e.g. defaulted state)
  • A rating assigned to an obligor when they first enter the rating system

ECB TRIM Requirements

A grade or pool is the subset of obligors or facilities to which the same PD is applied for the calculation of regulatory capital requirements, irrespective of how this PD has been assigned (e.g. through the use of masterscales)[1]

Distribution of obligors across grades

The number of grades and pools is adequate to achieve meaningful risk differentiation and quantification of the PD at the grade or pool level. To comply with this requirement, institutions should:

  • justify the criteria applied when determining the number of grades or pools and the proportion of obligors or facilities assigned to each;
  • ensure that the concentration of numbers of obligors or facilities is not excessive in any grade or pool; any significant concentrations should be supported by convincing empirical evidence of the homogeneity of risk for those obligors or facilities;
  • ensure that no grade or pool has too few obligors or facilities, unless this is supported by convincing empirical evidence of the adequacy of the grouping of the exposures in question.

Homogeneity within grades

The structure of rating systems must ensure the homogeneity of obligors or facilities assigned to the same grade or pool:

  • homogeneity is understood as obligors or facilities assigned to a grade having a reasonably similar default risk to ensure that the grade-level default rate is representative of all obligors or facilities in that grade;
  • in cases where it is found (through the use of additional drivers or a different discretisation of the existing ones) that a material subset of obligors or facilities within a grade/pool yields a significantly different default rate to that of the rest of the grade or pool, this is considered to indicate a lack of homogeneity

Risk differentiation across grades

Institutions should ensure that there are no significant overlaps in the distribution of the default risk between grades or pools. This should be ensured through a meaningful differentiation of the default rates of each grade.

Mapping to External Rating Scales

The ECB interprets the possibility for institutions to attribute the default rate observed for the grades of a rating agency or similar organisation to its own grades in accordance with Article 180(1)(f) of the CRR as being equivalent to the use of external data for PD quantification at a more aggregated level (external grade) rather than at the obligor/facility level. Accordingly, sections 3.2 and 4.2.2 of this chapter are relevant for institutions that do so.

In accordance with Article 180(1)(f) of the CRR, mappings must be based on a comparison of internal rating criteria with the criteria used by the external organisation and on a comparison of the internal and external ratings of any common obligors. Biases or inconsistencies in the mapping approach or underlying data must be avoided. To comply with these requirements, institutions should follow the paragraphs listed below.

  • Institutions should ensure that the quality of the mapping between internal and external rating scales at a given date and over time is consistent and provides for an adequate level of predictive ability. They should make sure that common obligors used as a basis for the mapping are sufficiently representative of the obligors in the application portfolio.
  • When mapping internal grades to external grades, institutions should document and analyse any differences between the external and internal rating scales, especially differences caused by adding further information for risk differentiation purposes
  • Institutions should adjust the external rating scale if such rating scale does not solely embed default risk. They should also document such adjustments.
  • When mapping internal grades to external grades and using the default rates of the external grades provided by the organisation, if the latter has a material number of obligors for which it no longer provides a rating (withdrawn rating), the institution should take this into account. It should adjust the external default rates accordingly, if necessary, and take into consideration the provisions of paragraph 75 of the EBA GL on PD and LGD. In the event that an adjustment is performed, the institution should add the necessary MoC.




  1. ECB guide to internal models - Credit Risk, Sep 2018

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