The concept of a Shadow (Credit) Rating is used in various contexts:
- when a credit rating agency develops an unsolicited rating for a borrower or credit asset
- when an internal model of a bank or other credit risk bearing firm targets external ratings provided by an External Credit Assessment Institution
ECB TRIM Requirements
A shadow rating model (SRM) is an internal rating approach that selects and weighs the risk drivers to be used for risk differentiation purposes by identifying the main factors that explain external ratings provided by an external credit assessment institution or similar organisation, rather than internal directly observed defaults.
Institutions should justify and document the rationale for the use (and the continued use) of the SRM, instead of the internal default prediction model, and also document the alternative approaches that have been considered. In addition, and without prejudice to the risk differentiation requirements, when developing the model institutions should set explicit threshold criteria in terms of capacity to explain the target ratings and take appropriate action when those thresholds are not met.
Assignment criteria and processes must be periodically reviewed to determine whether they remain appropriate for the current portfolio and external conditions. To comply with this requirement, as part of the review of estimates institutions should take all reasonable steps to demonstrate how the model performs on the application population in terms of predicting defaults or, if that is not possible (when there are not enough internal default data), at least in terms of predicting the target ratings.
Meaning of Rating Scales
In accordance with Article 170(1)(b) of the CRR, institutions’ rating systems must have an obligor rating scale which reflects exclusively the quantification of the risk of obligor default. To this end, institutions should adjust the ratings used as targets for their SRMs if they do not solely embed default risk. They should also document such adjustments.
In accordance with Article 174(1)(a) of the CRR, when an institution uses a statistical model and other mechanical methods to assign exposures to obligors or facilities, the input variables must form a reasonable and effective basis for the resulting predictions. To comply with this requirement, when the institution uses an SRM, external ratings should not be used as risk drivers in addition to target variables.
Information Content Differences
When assigning obligors and facilities to grades or pools institutions must take all relevant information into account. To comply with this requirement, when different information sources are used institutions should ensure that they understand the impact of any differences between these sources and establish adequate procedures to ensure that these differences are adequately addressed.
In addition, institutions should account for situations where entities switch from rated to non-rated status for the target ratings over time, including when the reason for non-rated status is not credit-related, and document this accordingly.
The data used to build the model must be representative of the population of the institution's actual obligors or exposures. To comply with this requirement, institutions should analyse and provide evidence of the representativeness of the data used for model development
- ECB guide to internal models - Credit Risk, Sep 2018