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Basel ii Accord
Section 444 to 485 |
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6. Use
of internal
ratings
444.
Internal ratings and default and loss estimates
must play an essential role in
the
credit
approval, risk management, internal capital
allocations, and corporate
governance
functions
of banks using the IRB approach.
Ratings
systems and estimates designed and implemented
exclusively for the purpose of qualifying for
the IRB approach and used only to provide IRB
inputs are not acceptable. It is recognised that
banks will not necessarily be using exactly the
same estimates for both IRB and all internal
purposes.
For
example, pricing models are likely to use PDs
and LGDs relevant to the life of the asset.
Where there are such differences, a bank must
document them and demonstrate their
reasonableness to the
supervisor.
445.
A bank must have a credible track record in the
use of internal ratings
information.
Thus,
the bank must demonstrate that it has been using
a rating system that was broadly
in
line
with the minimum requirements articulated in
this document for at least the three
years
prior
to qualification.
A
bank using the advanced IRB approach must
demonstrate that it has been estimating and
employing LGDs and EADs in a manner that is
broadly consistent with the minimum requirements
for use of own estimates of LGDs and EADs for at
least the three years prior to qualification.
Improvements to a bank’s rating system will not
render a bank non-compliant with the three-year
requirement.
7. Risk
quantification
(i)
Overall requirements for
estimation
Structure
and intent
446.
This section addresses the broad standards for
own-estimates of PD, LGD, and
EAD. Generally, all
banks using the IRB approaches must estimate a
PD (88) for each
internal
borrower grade for corporate, sovereign and bank
exposures or for each pool in the case of retail
exposures.
(88) Banks are not required to
produce their own estimates of PD for certain
equity exposures and certain exposures that fall
within the SL
sub-classes.
447.
PD estimates must be a long-run average of
one-year default rates for borrowers
in
the
grade, with the exception of retail exposures
(see below). Requirements specific to
PD
estimation
are provided in paragraphs 461 to 467. Banks on
the advanced approach must
estimate
an appropriate LGD (as defined in paragraphs 468
to 473) for each of its
facilities
(or
retail pools). Banks on the advanced approach
must also estimate an appropriate longrun
default-weighted average EAD for each of its
facilities as defined in paragraphs 474 and 475.
Requirements
specific to EAD estimation appear in paragraphs
474 to 479. For
corporate,
sovereign and bank exposures, banks that do not
meet the requirements for ownestimates of EAD or
LGD, above, must use the supervisory estimates
of these parameters. Standards for use of such
estimates are set out in paragraphs 506 to
524.
448.
Internal estimates of PD, LGD, and EAD must
incorporate all relevant, material
and
available
data, information and methods. A bank may
utilise internal data and data
from
external
sources (including pooled data). Where internal
or external data is used, the
bank
must
demonstrate that its estimates are
representative of long run
experience.
449.
Estimates must be grounded in historical
experience and empirical evidence,
and
not
based purely on subjective or judgmental
considerations. Any changes in
lending
practice
or the process for pursuing recoveries over the
observation period must be
taken
into
account. A bank’s estimates must promptly
reflect the implications of technical advances
and new data and other information, as it
becomes available. Banks must review their
estimates on a yearly basis or more
frequently.
450.
The population of exposures represented in the
data used for estimation, and
lending
standards in use when the data were generated,
and other relevant
characteristics
should
be closely matched to or at least comparable
with those of the bank’s exposures
and
standards.
The bank must also demonstrate that economic or
market conditions that underlie the data are
relevant to current and foreseeable conditions.
For
estimates of LGD and EAD, banks must take into
account paragraphs 468 to 479. The number of
exposures in the sample and the data period used
for quantification must be sufficient to provide
the bank with confidence in the accuracy and
robustness of its estimates. The estimation
technique must perform well in out-of-sample
tests.
451.
In general, estimates of PDs, LGDs, and EADs are
likely to involve unpredictable
errors.
In order to avoid over-optimism, a bank must add
to its estimates a margin of
conservatism
that is related to the likely range of errors.
Where methods and data are less
satisfactory
and the likely range of errors is larger, the
margin of conservatism must be
larger.
Supervisors may allow some flexibility in
application of the required standards for
data
that
are collected prior to the date of
implementation of this Framework.
However,
in such cases banks must demonstrate to their
supervisors that appropriate adjustments have
been made to achieve broad equivalence to the
data without such flexibility. Data collected
beyond the date of implementation must conform
to the minimum standards unless otherwise
stated.
(ii)
Definition of default
452.
A default is considered to have occurred with
regard to a particular obligor
when
either
or both of the two following events have taken
place.
•
The
bank considers that the obligor is unlikely to
pay its credit obligations to
the
banking
group in full, without recourse by the bank to
actions such as realising
security
(if held).
•
The
obligor is past due more than 90 days on any
material credit obligation to
the
banking
group.
(89) Overdrafts will be
considered as being past due once the
customer
has
breached an advised limit or been advised of a
limit smaller than current
outstandings.
(89) In the case of retail and PSE
obligations, for the 90 days figure, a
supervisor may substitute a figure up to 180
days for different products, as it considers
appropriate to local conditions. In one member
country, local conditions make it appropriate to
use a figure of up to 180 days also for lending
by its banks to corporates; this applies for a
transitional period of 5
years.
453.
The elements to be taken as indications of
unlikeliness to pay include:
•
The
bank puts the credit obligation on non-accrued
status.
•
The
bank makes a charge-off or account-specific
provision resulting from a
significant
perceived decline in credit quality subsequent
to the bank taking on the
exposure.
(90)
•
The
bank sells the credit obligation at a material
credit-related economic
loss.
•
The
bank consents to a distressed restructuring of
the credit obligation where this
is
likely
to result in a diminished financial obligation
caused by the material
forgiveness, or
postponement, of principal, interest or (where
relevant) fees.
(91)
•
The
bank has filed for the obligor’s bankruptcy or a
similar order in respect of
the
obligor’s
credit obligation to the banking
group.
The
obligor has sought or has been placed in
bankruptcy or similar protection
where
this
would avoid or delay repayment of the credit
obligation to the banking
group.
(90) In some jurisdictions,
specific provisions on equity exposures are set
aside for price risk and do not signal
default.
(91) Including, in the case of
equity holdings assessed under a PD/LGD
approach, such distressed restructuring of the
equity itself.
454.
National supervisors will provide appropriate
guidance as to how these
elements
must
be implemented and monitored.
455.
For retail exposures, the definition of default
can be applied at the level of
a
particular
facility, rather than at the level of the
obligor. As such, default by a borrower on one
obligation does not require a bank to treat all
other obligations to the banking group
as
defaulted.
456.
A bank must record actual defaults on IRB
exposure classes using this
reference
definition.
A bank must also use the reference definition
for its estimation of PDs, and
(where
relevant)
LGDs and EADs. In arriving at these estimations,
a bank may use external data
available
to it that is not itself consistent with that
definition, subject to the requirements
set
out
in paragraph 462.
However,
in such cases, banks must demonstrate to their
supervisors that appropriate adjustments to the
data have been made to achieve broad equivalence
with the reference definition. This same
condition would apply to any internal data used
up to implementation of this Framework. Internal
data (including that pooled by banks) used in
such estimates beyond the date of implementation
of this Framework must be consistent
with
the
reference definition.
457.
If the bank considers that a previously
defaulted exposure’s status is such that
no
trigger
of the reference definition any longer applies,
the bank must rate the borrower
and
estimate
LGD as they would for a non-defaulted facility.
Should the reference definition
subsequently
be triggered, a second default would be deemed
to have occurred.
(iii)
Re-ageing
458.
The bank must have clearly articulated and
documented policies in respect of
the
counting
of days past due, in particular in respect of
the re-ageing of the facilities and
the
granting
of extensions, deferrals, renewals and rewrites
to existing accounts. At a
minimum,
the
re-ageing policy must include:
(a)
approval authorities and reporting requirements;
(b)
minimum age of a facility before it is eligible
for re-ageing;
(c)
delinquency levels of facilities that are
eligible for re-ageing;
(d)
maximum number of re-ageings per facility;
and
(e)
a reassessment of the borrower’s capacity to
repay.
These
policies must be applied consistently over time,
and must support the ‘use test’ (i.e. if a bank
treats a re-aged exposure in a similar fashion
to other delinquent exposures more than the
past-due cut off point, this exposure must be
recorded as in default for IRB purposes). Some
supervisors may choose to establish more
specific requirements on re-ageing for banks in
their jurisdiction.
(iv)
Treatment of overdrafts
459.
Authorised overdrafts must be subject to a
credit limit set by the bank and brought
to
the
knowledge of the client. Any break of this limit
must be monitored; if the account were not
brought under the limit after 90 to 180 days
(subject to the applicable past-due trigger),
it
would
be considered as defaulted. Non-authorised
overdrafts will be associated with a
zero
limit
for IRB purposes.
Thus,
days past due commence once any credit is
granted to an unauthorised customer; if such
credit were not repaid within 90 to 180 days,
the exposure would be considered in default.
Banks must have in place rigorous internal
policies for assessing the creditworthiness of
customers who are offered overdraft
accounts.
(v)
Definition of loss for all asset
classes
460.
The definition of loss used in estimating LGD is
economic loss. When measuring
economic
loss, all relevant factors should be taken into
account. This must include
material
discount
effects and material direct and indirect costs
associated with collecting on
the
exposure.
Banks must not simply measure the loss recorded
in accounting records, although they must be
able to compare accounting and economic losses.
The bank’s own workout and collection expertise
significantly influences their recovery rates
and must be reflected in their LGD estimates,
but adjustments to estimates for such expertise
must be conservative until the bank has
sufficient internal empirical evidence of the
impact of its expertise.
(vi)
Requirements specific to PD
estimation
Corporate,
sovereign, and bank
exposures
461.
Banks must use information and techniques that
take appropriate account of the
long-run
experience when estimating the average PD for
each rating grade. For example,
banks
may use one or more of the three specific
techniques set out below: internal
default
experience,
mapping to external data, and statistical
default models.
462.
Banks may have a primary technique and use
others as a point of comparison
and
potential
adjustment. Supervisors will not be satisfied by
mechanical application of a
technique
without supporting analysis. Banks must
recognise the importance of
judgmental
considerations
in combining results of techniques and in making
adjustments for limitations
of
techniques and information.
•
A
bank may use data on internal default experience
for the estimation of PD. A
bank
must
demonstrate in its analysis that the estimates
are reflective of underwriting
standards
and of any differences in the rating system that
generated the data and
the
current rating system. Where only limited data
are available, or where
underwriting
standards or rating systems have changed, the
bank must add a
greater
margin of conservatism in its estimate of PD.
The use of pooled data across
institutions
may also be recognised. A bank must demonstrate
that the internal
rating
systems and criteria of other banks in the pool
are comparable with its own.
•
Banks
may associate or map their internal grades to
the scale used by an
external
credit
assessment institution or similar institution
and then attribute the default
rate
observed
for the external institution’s grades to the
bank’s grades. Mappings must
be
based on a comparison of internal rating
criteria to the criteria used by
the
external
institution and on a comparison of the internal
and external ratings of any
common
borrowers. Biases or inconsistencies in the
mapping approach or
underlying
data must be avoided. The external institution’s
criteria underlying the
data
used for quantification must be oriented to the
risk of the borrower and not
reflect
transaction characteristics. The bank’s analysis
must include a comparison of
the
default definitions used, subject to the
requirements in paragraph 452 to
457.
The
bank must document the basis for the
mapping.
•
A
bank is allowed to use a simple average of
default-probability estimates
for
individual
borrowers in a given grade, where such estimates
are drawn from
statistical
default prediction models. The bank’s use of
default probability models for
this
purpose must meet the standards specified in
paragraph 417.
463.
Irrespective of whether a bank is using
external, internal, or pooled data sources,
or
a
combination of the three, for its PD estimation,
the length of the underlying
historical
observation
period used must be at least five years for at
least one source. If the
available
observation
period spans a longer period for any source, and
this data are relevant and
material,
this longer period must be
used.
Retail
exposures
464.
Given the bank-specific basis of assigning
exposures to pools, banks must
regard
internal
data as the primary source of information for
estimating loss characteristics.
Banks
are
permitted to use external data or statistical
models for quantification provided a
strong
link
can be demonstrated between (a) the bank’s
process of assigning exposures to a
pool
and
the process used by the external data source,
and (b) between the bank’s internal
risk
profile
and the composition of the external data. In all
cases banks must use all relevant
and
material
data sources as points of
comparison.
465.
One method for deriving long-run average
estimates of PD and
default-weighted
average
loss rates given default (as defined in
paragraph 468) for retail would be based
on
an
estimate of the expected long-run loss rate. A
bank may (i) use an appropriate
PD
estimate
to infer the long-run default-weighted average
loss rate given default, or (ii) use
a
long-run
default-weighted average loss rate given default
to infer the appropriate PD. In
either
case, it is important to recognise that the LGD
used for the IRB capital
calculation
cannot
be less than the long-run default-weighted
average loss rate given default and
must
be
consistent with the concepts defined in
paragraph 468.
466.
Irrespective of whether banks are using
external, internal, pooled data sources, or
a
combination
of the three, for their estimation of loss
characteristics, the length of
the
underlying
historical observation period used must be at
least five years. If the
available
observation
spans a longer period for any source, and these
data are relevant, this longer
period
must be used. A bank need not give equal
importance to historic data if it
can
convince
its supervisor that more recent data are a
better predictor of loss rates.
467.
The Committee recognises that seasoning can be
quite material for some
long-term
retail
exposures characterised by seasoning effects
that peak several years after
origination.
Banks
should anticipate the implications of rapid
exposure growth and take steps to
ensure
that
their estimation techniques are accurate, and
that their current capital level and earnings
and funding prospects are adequate to cover
their future capital needs. In order to avoid
gyrations in their required capital positions
arising from short-term PD horizons, banks are
also encouraged to adjust PD estimates upward
for anticipated seasoning effects, provided such
adjustments are applied in a consistent fashion
over time. Within some jurisdictions, such
adjustments might be made mandatory, subject to
supervisory discretion.
(vii)
Requirements specific to own-LGD
estimates
Standards
for all asset classes
468.
A bank must estimate an LGD for each facility
that aims to reflect economic
downturn
conditions where necessary to capture the
relevant risks. This LGD cannot be
less
than
the long-run default-weighted average loss rate
given default calculated based on
the
average
economic loss of all observed defaults within
the data source for that type of
facility.
In
addition, a bank must take into account the
potential for the LGD of the facility to be
higher than the default-weighted average during
a period when credit losses are substantially
higher than average.
For
certain types of exposures, loss severities may
not exhibit such cyclical variability and LGD
estimates may not differ materially (or possibly
at all) from the long-run default-weighted
average. However, for other exposures, this
cyclical variability in loss severities may be
important and banks will need to incorporate it
into their LGD estimates.
For
this purpose, banks may use averages of loss
severities observed during periods of
high
credit
losses, forecasts based on appropriately
conservative assumptions, or other
similar
methods.
Appropriate estimates of LGD during periods of
high credit losses might be formed using either
internal and/or external data. Supervisors will
continue to monitor and encourage the
development of appropriate approaches to this
issue.
469.
In its analysis, the bank must consider the
extent of any dependence between
the
risk
of the borrower and that of the collateral or
collateral provider. Cases where there is
a
significant
degree of dependence must be addressed in a
conservative manner. Any
currency
mismatch between the underlying obligation and
the collateral must also be
considered
and treated conservatively in the bank’s
assessment of LGD.
470.
LGD estimates must be grounded in historical
recovery rates and, when
applicable,
must
not solely be based on the collateral’s
estimated market value. This
requirement
recognises
the potential inability of banks to gain both
control of their collateral and
liquidate
it
expeditiously. To the extent, that LGD estimates
take into account the existence
of
collateral,
banks must establish internal requirements for
collateral management, operational procedures,
legal certainty and risk management process that
are generally consistent with those required for
the standardised approach.
471.
Recognising the principle that realised losses
can at times systematically
exceed
expected
levels, the LGD assigned to a defaulted asset
should reflect the possibility that
the
bank
would have to recognise additional, unexpected
losses during the recovery period.
For
each
defaulted asset, the bank must also construct
its best estimate of the expected loss
on
that
asset based on current economic circumstances
and facility status.
The
amount, if any, by which the LGD on a defaulted
asset exceeds the bank’s best estimate of
expected loss on the asset represents the
capital requirement for that asset, and should
be set by the bank on a risk-sensitive basis in
accordance with paragraphs 272 and 328 to 330.
Instances where the best estimate of expected
loss on a defaulted asset is less than the sum
of specific provisions and partial charge-offs
on that asset will attract supervisory scrutiny
and must be justified by the
bank.
Additional
standards for corporate, sovereign, and bank
exposures
472.
Estimates of LGD must be based on a minimum data
observation period that should
ideally
cover at least one complete economic cycle but
must in any case be no shorter than
a
period
of seven years for at least one source. If the
available observation period spans
a
longer
period for any source, and the data are
relevant, this longer period must be
used.
Additional
standards for retail
exposures
473.
The minimum data observation period for LGD
estimates for retail exposures is
five
years.
The less data a bank has, the more conservative
it must be in its estimation. A
bank
need
not give equal importance to historic data if it
can demonstrate to its supervisor
that
more
recent data are a better predictor of loss
rates.
(viii)
Requirements specific to own-EAD
estimates
Standards
for all asset classes
474.
EAD for an on-balance sheet or off-balance sheet
item is defined as the expected
gross
exposure of the facility upon default of the
obligor. For on-balance sheet items,
banks
must
estimate EAD at no less than the current drawn
amount, subject to recognising
the
effects
of on-balance sheet netting as specified in the
foundation approach. The
minimum
requirements
for the recognition of netting are the same as
those under the foundation
approach.
The
additional minimum requirements for internal
estimation of EAD under the
advanced
approach, therefore, focus on the estimation of
EAD for off-balance sheet items
(excluding
transactions that expose banks to counterparty
credit risk as set out in Annex
4).
Advanced
approach banks must have established procedures
in place for the estimation of
EAD
for off-balance sheet items. These must specify
the estimates of EAD to be used
for
each
facility type. Banks estimates of EAD should
reflect the possibility of additional drawings
by the borrower up to and after the time a
default event is triggered. Where estimates of
EAD differ by facility type, the delineation of
these facilities must be clear and
unambiguous.
475.
Advanced approach banks must assign an estimate
of EAD for each facility. It
must
be
an estimate of the long-run default-weighted
average EAD for similar facilities
and
borrowers
over a sufficiently long period of time, but
with a margin of conservatism
appropriate
to the likely range of errors in the estimate.
If
a positive correlation can reasonably be
expected between the default frequency and the
magnitude of EAD, the EAD estimate must
incorporate a larger margin of conservatism.
Moreover, for exposures for which EAD estimates
are volatile over the economic cycle, the bank
must use EAD estimates that are appropriate for
an economic downturn, if these are more
conservative than the longrun average.
For
banks that have been able to develop their own
EAD models, this could be
achieved
by considering the cyclical nature, if any, of
the drivers of such models.
Other
banks
may have sufficient internal data to examine the
impact of previous
recession(s).
However,
some banks may only have the option of making
conservative use of external
data.
476.
The criteria by which estimates of EAD are
derived must be plausible and
intuitive,
and
represent what the bank believes to be the
material drivers of EAD. The choices must be
supported by credible internal analysis by the
bank. The bank must be able to provide
a
breakdown
of its EAD experience by the factors it sees as
the drivers of EAD. A bank must
use
all relevant and material information in its
derivation of EAD estimates. Across
facility
types,
a bank must review its estimates of EAD when
material new information comes to light and at
least on an annual basis.
477.
Due consideration must be paid by the bank to
its specific policies and
strategies
adopted
in respect of account monitoring and payment
processing. The bank must also
consider
its ability and willingness to prevent further
drawings in circumstances short
of
payment
default, such as covenant violations or other
technical default events. Banks
must
also
have adequate systems and procedures in place to
monitor facility amounts,
current
outstandings
against committed lines and changes in
outstandings per borrower and
per
grade.
The bank must be able to monitor outstanding
balances on a daily basis.
477
(i). For transactions that expose banks to
counterparty credit risk, estimates of
EAD
must
fulfil the requirements set forth in Annex 4 of
this Framework.
Additional
standards for corporate, sovereign, and bank
exposures
478.
Estimates of EAD must be based on a time period
that must ideally cover a
complete
economic cycle but must in any case be no
shorter than a period of seven years.
If
the
available observation period spans a longer
period for any source, and the data
are
relevant,
this longer period must be used. EAD estimates
must be calculated using a defaultweighted
average and not a time-weighted
average.
Additional
standards for retail
exposures
479.
The minimum data observation period for EAD
estimates for retail exposures is
five
years.
The less data a bank has, the more conservative
it must be in its estimation. A
bank
need
not give equal importance to historic data if it
can demonstrate to its supervisor
that
more
recent data are a better predictor of
drawdowns.
(ix)
Minimum requirements for assessing effect of
guarantees and credit
derivatives
Standards
for corporate, sovereign, and bank exposures
where own estimates of LGD are
used
and standards for retail
exposures
Guarantees
480.
When a bank uses its own estimates of LGD, it
may reflect the risk-mitigating
effect
of
guarantees through an adjustment to PD or LGD
estimates. The option to adjust LGDs
is
available
only to those banks that have been approved to
use their own internal estimates
of
LGD.
For retail exposures, where guarantees exist,
either in support of an
individual
obligation
or a pool of exposures, a bank may reflect the
risk-reducing effect either
through
its
estimates of PD or LGD, provided this is done
consistently. In adopting one or the
other
technique,
a bank must adopt a consistent approach, both
across types of guarantees and
over
time.
481.
In all cases, both the borrower and all
recognised guarantors must be assigned
a
borrower
rating at the outset and on an ongoing basis. A
bank must follow all minimum
requirements
for assigning borrower ratings set out in this
document, including the regular
monitoring
of the guarantor’s condition and ability and
willingness to honour its
obligations.
Consistent
with the requirements in paragraphs 430 and 431,
a bank must retain all relevant
information
on the borrower absent the guarantee and the
guarantor. In the case of
retail
guarantees,
these requirements also apply to the assignment
of an exposure to a pool, and
the
estimation of PD.
482.
In no case can the bank assign the guaranteed
exposure an adjusted PD or LGD
such
that the adjusted risk weight would be lower
than that of a comparable, direct
exposure
to
the guarantor. Neither criteria nor rating
processes are permitted to consider
possible
favourable
effects of imperfect expected correlation
between default events for the
borrower
and
guarantor for purposes of regulatory minimum
capital requirements. As such,
the
adjusted
risk weight must not reflect the risk mitigation
of “double default.”
Eligible
guarantors and
guarantees
483.
There are no restrictions on the types of
eligible guarantors. The bank
must,
however,
have clearly specified criteria for the types of
guarantors it will recognise
for
regulatory
capital purposes.
484.
The guarantee must be evidenced in writing,
non-cancellable on the part of
the
guarantor,
in force until the debt is satisfied in full (to
the extent of the amount and tenor
of
the
guarantee) and legally enforceable against the
guarantor in a jurisdiction where
the
guarantor
has assets to attach and enforce a judgement.
However, in contrast to the
foundation
approach to corporate, bank, and sovereign
exposures, guarantees
prescribing
conditions
under which the guarantor may not be obliged to
perform (conditional guarantees) may be
recognised under certain conditions.
Specifically, the onus is on the bank to
demonstrate that the assignment criteria
adequately address any potential reduction in
the risk mitigation effect.
Adjustment
criteria
485.
A bank must have clearly specified criteria for
adjusting borrower grades or
LGD
estimates
(or in the case of retail and eligible purchased
receivables, the process of
allocating
exposures to pools) to reflect the impact of
guarantees for regulatory
capital
purposes.
These criteria must be as detailed as the
criteria for assigning exposures
to
grades
consistent with paragraphs 410 and 411, and must
follow all minimum requirements
for
assigning borrower or facility ratings set out
in this document.
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