How to Create a Credit Risk Rating System
Contents
How to Create a Credit Risk Rating System
Creating a Credit Rating System is a task for financial institutions or other entities face material Credit Risk exposure through their clients or other counterparties. The objective of a rating system is to rank borrowers systematically with meaningful credit risk quality differentiation, thereby assisting effective Credit Portfolio Management
Decision Points
- Is the entity building the rating system formally regulated as a financial intermediary? This determines the minimum requirements from a regulatory perspective and fixes the applicable rules in a given jurisdiction
- What is the level of materiality of the Credit Portfolio. This determines the amount of resources that can reasonably be dedicated to the setup and maintainance of the rating system.
- What is the nature of the business model of the firm? This determines both primary sources of Risk Data and typical required risk measures
Regulatory Required Components
A credit rating system compliant with regulation will include a number of components depending on the complexity and scope of its application. For regulated firms the credit rating system must comply with applicable regulations (Basel III) and will, in particular, provide certain stylized Risk Parameters. Institutions must have specific definitions, processes and criteria for assigning exposures to grades or pools. The grade and pool definitions must be sufficiently detailed.
- A Credit Rating Scale, a limited set of states to which all exposures are classified
- Specific rating definitions, processes and criteria for assigning exposures to grades, collectively denoted as the Credit Rating Philosophy
- Probability of Default Models (for a single period or a full Term Structure
- Loss Given Default Models
- Exposure At Default Models
See Also
References
