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How to Build an Internal Rating System for Basel II Aidan O’Mahony Managing Director Tel: +44 207 826 3518 Standard & Poor...
Risk Solutions was formed in 2001 in response to client demand for tools and services to better manage credit risk exposur...
Agenda <ul><li>Key attributes of an Internal Rating System </li></ul><ul><li>Expected Loss Framework </li></ul><ul><li>Rat...
What is an Internal Rating System ? Consistent rating approach across all classes  Desk-top IT application – intranet deli...
Facility/ Exposure details Ratings summary Collateral and LGD details Qualitative inputs Audit Trail <ul><ul><li>Overview ...
Rating and PDs: Internal  Ratings System (RMS)  Qualitative assessment Quantitative Assessment S&P’s Rating Templates Exte...
<ul><ul><li>1. Key Attributes of an Effective </li></ul></ul><ul><ul><li>Internal Rating System </li></ul></ul><ul><li>Con...
<ul><ul><li>2. Expected Loss Framework </li></ul></ul><ul><li>Each prospective or existing loan facility must undergo thre...
3. Ratings and Pds Across different asset classes <ul><ul><li>The methodologies used for assessment of creditworthiness of...
Large corporates and  specialised lending  <ul><ul><li>Characteristics of these sectors </li></ul></ul><ul><ul><li>Relativ...
Large corporates and specialised lending   Sample template – Insurance Companies European Bank Evaluation of Qualitative F...
Clear and consistent rating criteria Large corporates and specialised lending   Sample template – Insurance Companies
Large corporates and specialised lending   Sample template – Insurance Companies Evaluation of Quantitative Factors Europe...
Quantitative Assessment Based on S&P’s Experience Benchmarks are provided per sector and market Large corporates and speci...
S&P Scale Internal Rating Scale <ul><li>Use of external    default data </li></ul><ul><li>Prepare for    CBO/CLO </li></ul...
<ul><ul><li>In the experience of S&P Risk Solutions, over the last few years, banks have adopted different modelling techn...
<ul><ul><li>4. Exposure and Facility Analysis </li></ul></ul>Stage 2: Exposure and Facility Analysis - Typically a corpora...
5. LGD and  Definition of default US BASEL II UK FRANCE GERMANY ITALY Credit obligation default 90 days credit obligation ...
0 10 20 30 40 50 60 70 Recovery (%) 5. LGD – Loss Given Default  -  LGD Behaviour in the US <ul><li>Average Overall Recove...
LGD Behaviour LGD Behaviour by debt Structure and Industry Overall - No Clear pattern!! <ul><li>Need More data </li></ul><...
Data Pooling Exercise:  Project Finance -  Case Study <ul><li>Project Finance Study consisted of 4 pioneer banks with hist...
<ul><li>Default analysis was performed </li></ul><ul><li>Cumulative Probabilities of Default were calculated </li></ul><ul...
Data Pooling: Next Steps <ul><li>Other data pooling initiatives underway: </li></ul><ul><li>SMEs: pan-European data poolin...
<ul><ul><li>Loss Given Default </li></ul></ul>Stage 3. Loss Given Default: LGD information is scarce and  complicated
<ul><ul><li>Expected Loss </li></ul></ul>
Concluding Comments  <ul><li>To build an internal rating system for Basel II you need: </li></ul><ul><li>Consistent rating...
A idan O’Mahony Managing Director Standard & Poor’s Risk Solutions Tel: + 44 20 7826-3 518 Fax: + 44 20 7826-3565 E-mail: ...
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How To Biuld Internal Rating System For Basel Ii

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  • Transcript of "How To Biuld Internal Rating System For Basel Ii"

    1. 1. How to Build an Internal Rating System for Basel II Aidan O’Mahony Managing Director Tel: +44 207 826 3518 Standard & Poor’s Risk Solutions
    2. 2. Risk Solutions was formed in 2001 in response to client demand for tools and services to better manage credit risk exposures. Risk Solutions is the customised risk management services arm of Standard & Poor’s focusing on: 1. Customised Credit Services (internal rating systems) 2. Credit Tools, Models, Data & Research (eg Pd & LGD) 3. Credit Training (Open enrolment and Custom Courses). Standard & Poor’s Risk Solutions
    3. 3. Agenda <ul><li>Key attributes of an Internal Rating System </li></ul><ul><li>Expected Loss Framework </li></ul><ul><li>Rating and PDs </li></ul><ul><li>Exposure and Facility tracking </li></ul><ul><li>Loss Given Default </li></ul><ul><li>Case Study – Rating Management System </li></ul><ul><li>Concluding Comments </li></ul>
    4. 4. What is an Internal Rating System ? Consistent rating approach across all classes Desk-top IT application – intranet delivered across an organisation Analytical and Management tool for tracking credit exposures and linking into Raroc models Satisfies Basel II Internal Ratings-Based Approach requirements
    5. 5. Facility/ Exposure details Ratings summary Collateral and LGD details Qualitative inputs Audit Trail <ul><ul><li>Overview of a </li></ul></ul><ul><ul><li>Rating Management System </li></ul></ul>Quantitative inputs
    6. 6. Rating and PDs: Internal Ratings System (RMS) Qualitative assessment Quantitative Assessment S&P’s Rating Templates External Ratings External Models Peer comparison Bank’s own internal view
    7. 7. <ul><ul><li>1. Key Attributes of an Effective </li></ul></ul><ul><ul><li>Internal Rating System </li></ul></ul><ul><li>Consistent analytical approach to ratings and PDs – all asset classes </li></ul><ul><li>Transparency of methodology; </li></ul><ul><li>Visible audit trail; </li></ul><ul><li>Logical workflow, including sign-off and permissions; </li></ul><ul><li>Open architecture with a modular approach that is easily adaptable and scalable; </li></ul><ul><li>Data access aligned with roles and responsibilities; and </li></ul><ul><li>Centralised information storage </li></ul>
    8. 8. <ul><ul><li>2. Expected Loss Framework </li></ul></ul><ul><li>Each prospective or existing loan facility must undergo three consecutive stages to determine expected loss. </li></ul>Stage 1 Stage 3 Stage 2 x x = Expected Loss Rating (PD) Corporates Banks Insurance Project Finance SME Exposure at Default Seniority Maturity etc Data Collateral Haircut Policy Loss Given Default
    9. 9. 3. Ratings and Pds Across different asset classes <ul><ul><li>The methodologies used for assessment of creditworthiness of different asset classes should balance: </li></ul></ul><ul><ul><ul><li>the volume and scope of data available, with </li></ul></ul></ul><ul><ul><ul><li>the relative exposure of the bank </li></ul></ul></ul>High volume of data + Low Exposure MODELS ARE SUITABLE Low volume of data + High Exposure RATING TEMPLATES ARE SUITABLE Typical Loan Book
    10. 10. Large corporates and specialised lending <ul><ul><li>Characteristics of these sectors </li></ul></ul><ul><ul><li>Relatively large exposures to individual obligors </li></ul></ul><ul><ul><li>Qualitative factors can account for more than 50% of the risk of obligors </li></ul></ul><ul><ul><li>Scarce number of defaulting companies </li></ul></ul><ul><ul><li>Limited historical track record from many banks in some sectors </li></ul></ul><ul><ul><li>Statistical models are NOT applicable in these sectors: </li></ul></ul><ul><ul><li>Models can severely underestimate the credit risk profile of obligors given the low proportion of historical defaults in the sectors. </li></ul></ul><ul><ul><li>Statistical models fail to include and ponder qualitative factors. </li></ul></ul><ul><ul><li>Models’ results can be highly volatile and with low predictive power. </li></ul></ul>
    11. 11. Large corporates and specialised lending Sample template – Insurance Companies European Bank Evaluation of Qualitative Factors Credit factors Weights
    12. 12. Clear and consistent rating criteria Large corporates and specialised lending Sample template – Insurance Companies
    13. 13. Large corporates and specialised lending Sample template – Insurance Companies Evaluation of Quantitative Factors European Bank
    14. 14. Quantitative Assessment Based on S&P’s Experience Benchmarks are provided per sector and market Large corporates and specialised lending Sample template – Insurance Companies
    15. 15. S&P Scale Internal Rating Scale <ul><li>Use of external default data </li></ul><ul><li>Prepare for CBO/CLO </li></ul>Satisfy board regarding the validity of an internal rating system Identify areas of inconsistency in order to improve an internal ratings process Backtest model results versus S&P ratings or estimates Compare results and map the scales Backtesting and Mapping to External Indicators of PD Large corporates and specialised lending Sample template – Insurance Companies 6 5 4 3 2 1 23.76 CCC 5.44 B 0.88 BB 0.19 BBB 0.02 A 0.02 AA 0 AAA 1-yr PD S&P 4 1 CCC 2 4 1 2 B 1 6 1 BB 1 5 BBB 1 5 A 1 2 3 AA 1 AAA 6 5 4 3 2 1
    16. 16. <ul><ul><li>In the experience of S&P Risk Solutions, over the last few years, banks have adopted different modelling techniques which in turn produce results in different scales. </li></ul></ul><ul><ul><li>Once an internal model is in place, it is important to ensure that the choice of methodology is adequate to the bank’s requirements / data, and that the methodology is applied consistently and produces reliable results </li></ul></ul>Modelling SMEs
    17. 17. <ul><ul><li>4. Exposure and Facility Analysis </li></ul></ul>Stage 2: Exposure and Facility Analysis - Typically a corporate obligor will have a number of facilities with a bank, including secured and unsecured loans and overdraft facilities
    18. 18. 5. LGD and Definition of default US BASEL II UK FRANCE GERMANY ITALY Credit obligation default 90 days credit obligation default Debt restructuring Bankruptcy <ul><li>T he definition of default is not the same in all countries, often bank behaviour is linked to national legal specificities </li></ul>
    19. 19. 0 10 20 30 40 50 60 70 Recovery (%) 5. LGD – Loss Given Default - LGD Behaviour in the US <ul><li>Average Overall Recovery By Industry, some differences </li></ul>Industries with 9+ Observations Automotive Comp. & Elec Retail Food & Drug Gaming & Hotel Services & Leasing Real Estate Metals & Mining Retail Textile & Apparel Transportation Average Building Materials Healthcare Oil & Gas Television Manu. & Machinery Printing & Pub. Food & Beverage
    20. 20. LGD Behaviour LGD Behaviour by debt Structure and Industry Overall - No Clear pattern!! <ul><li>Need More data </li></ul><ul><li>Clear definitions </li></ul><ul><li>Need to pool data </li></ul>
    21. 21. Data Pooling Exercise: Project Finance - Case Study <ul><li>Project Finance Study consisted of 4 pioneer banks with historical data through the 1 st quarter 2002. </li></ul><ul><li>Now 20 banks worldwide involved in data pooling with S&P Risk Solutions </li></ul><ul><li>Definitions were agreed upon of : </li></ul><ul><ul><li>Project Finance Loans were agreed upon </li></ul></ul><ul><ul><li>Default definitions were agreed upon </li></ul></ul><ul><ul><li>Definitions of emergence was agreed upon </li></ul></ul><ul><li>Data was collected from as far back as 1983 </li></ul><ul><li>Data was validated </li></ul><ul><li>Projects with multiple bank participants were matched together </li></ul><ul><li>Basel willing to accept pooled data </li></ul>
    22. 22. <ul><li>Default analysis was performed </li></ul><ul><li>Cumulative Probabilities of Default were calculated </li></ul><ul><li>Confidentiality was maintained throughout the process </li></ul>Data Pooling Exercise: Case Study Analysis: Results: <ul><li>Average default rate of 7% </li></ul><ul><li>Average Recovery Rate of 75% </li></ul>
    23. 23. Data Pooling: Next Steps <ul><li>Other data pooling initiatives underway: </li></ul><ul><li>SMEs: pan-European data pooling initiative </li></ul><ul><li>Leveraged Finance: </li></ul><ul><li>Large Corporates </li></ul>
    24. 24. <ul><ul><li>Loss Given Default </li></ul></ul>Stage 3. Loss Given Default: LGD information is scarce and complicated
    25. 25. <ul><ul><li>Expected Loss </li></ul></ul>
    26. 26. Concluding Comments <ul><li>To build an internal rating system for Basel II you need: </li></ul><ul><li>Consistent rating methodology across asset classes </li></ul><ul><li>Use an expected loss framework </li></ul><ul><li>Data to calibrate Pd and LGD inputs </li></ul><ul><li>Logical and transparent workflow desk-top application </li></ul><ul><li>Appropriate back-testing and validation. </li></ul><ul><li>Standard & Poor’s Risk Solutions </li></ul>
    27. 27. A idan O’Mahony Managing Director Standard & Poor’s Risk Solutions Tel: + 44 20 7826-3 518 Fax: + 44 20 7826-3565 E-mail: Aidan_O’Mahony @StandardAndPoors.com Standard &Poor’s Risk Solutions Garden House 18 Finsbury Circus London EC2M 7NJ United Kingdom Contacts
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