4. Risk rating system operations

(i) Coverage of ratings

422. For corporate, sovereign, and bank exposures, each borrower and all recognised guarantors must be assigned a rating and each exposure must be associated with a facility rating as part of the loan approval process.

Similarly, for retail, each exposure must be assigned to a pool as part of the loan approval process.

423. Each separate legal entity to which the bank is exposed must be separately rated.

A bank must have policies acceptable to its supervisor regarding the treatment of individual entities in a connected group including circumstances under which the same rating may or may not be assigned to some or all related entities.

(ii) Integrity of rating process

Standards for corporate, sovereign, and bank exposures

424. Rating assignments and periodic rating reviews must be completed or approved by a party that does not directly stand to benefit from the extension of credit.

Independence of the rating assignment process can be achieved through a range of practices that will be
carefully reviewed by supervisors.

These operational processes must be documented in the bank’s procedures and incorporated into bank policies.

Credit policies and underwriting procedures must reinforce and foster the independence of the rating process.

425. Borrowers and facilities must have their ratings refreshed at least on an annual basis.

Certain credits, especially higher risk borrowers or problem exposures, must be subject to more frequent review.

In addition, banks must initiate a new rating if material information on the borrower or facility comes to light.

426. The bank must have an effective process to obtain and update relevant and material information on the borrower’s financial condition, and on facility characteristics that affect LGDs and EADs (such as the condition of collateral).

Upon receipt, the bank needs to have a procedure to update the borrower’s rating in a timely fashion.

Standards for retail exposures

427. A bank must review the loss characteristics and delinquency status of each identified risk pool on at least an annual basis.

It must also review the status of individual borrowers within each pool as a means of ensuring that exposures continue to be assigned to the correct pool.

This requirement may be satisfied by review of a representative sample of exposures in the pool.

(iii) Overrides

428. For rating assignments based on expert judgement, banks must clearly articulate the situations in which bank officers may override the outputs of the rating process, including how and to what extent such overrides can be used and by whom.

For model-based ratings, the bank must have guidelines and processes for monitoring cases where human judgement has overridden the model’s rating, variables were excluded or inputs were altered.

These guidelines must include identifying personnel that are responsible for approving these overrides.

Banks must identify overrides and separately track their performance.

(iv) Data maintenance

429. A bank must collect and store data on key borrower and facility characteristics to provide effective support to its internal credit risk measurement and management process, to enable the bank to meet the other requirements in this document, and to serve as a basis for supervisory reporting.

These data should be sufficiently detailed to allow retrospective reallocation of obligors and facilities to grades, for example if increasing sophistication of the internal rating system suggests that finer segregation of portfolios can be achieved.

Furthermore, banks must collect and retain data on aspects of their internal ratings as required under Pillar 3 of this Framework.

For corporate, sovereign, and bank exposures

430. Banks must maintain rating histories on borrowers and recognised guarantors, including the rating since the borrower/guarantor was assigned an internal grade, the dates the ratings were assigned, the methodology and key data used to derive the rating and the person/model responsible.

The identity of borrowers and facilities that default, and the timing and circumstances of such defaults, must be retained.

Banks must also retain data on the PDs and realised default rates associated with rating grades and ratings migration in order to track the predictive power of the borrower rating system.

431. Banks using the advanced IRB approach must also collect and store a complete history of data on the LGD and EAD estimates associated with each facility and the key data used to derive the estimate and the person/model responsible.

Banks must also collect data on the estimated and realised LGDs and EADs associated with each defaulted facility.

Banks that reflect the credit risk mitigating effects of guarantees/credit derivatives through LGD must retain data on the LGD of the facility before and after evaluation of the effects of the guarantee/credit derivative.

Information about the components of loss or recovery for each defaulted exposure must be retained, such as amounts recovered, source of recovery (e.g. collateral, liquidation proceeds and guarantees), time period required for recovery, and administrative costs.

432. Banks under the foundation approach which utilise supervisory estimates are encouraged to retain the relevant data (i.e. data on loss and recovery experience for corporate exposures under the foundation approach, data on realised losses for banks using the supervisory slotting criteria for SL).

For retail exposures

433. Banks must retain data used in the process of allocating exposures to pools, including data on borrower and transaction risk characteristics used either directly or through use of a model, as well as data on delinquency.

Banks must also retain data on the estimated PDs, LGDs and EADs, associated with pools of exposures.

For defaulted exposures, banks must retain the data on the pools to which the exposure was assigned over the year prior to default and the realised outcomes on LGD and EAD.

(v) Stress tests used in assessment of capital adequacy

434. An IRB bank must have in place sound stress testing processes for use in the assessment of capital adequacy. Stress testing must involve identifying possible events or future changes in economic conditions that could have unfavourable effects on a bank’s credit exposures and assessment of the bank’s ability to withstand such changes.

Examples of scenarios that could be used are

(i) economic or industry downturns;

(ii) market-risk events; and

(iii) liquidity conditions.

435. In addition to the more general tests described above, the bank must perform a credit risk stress test to assess the effect of certain specific conditions on its IRB regulatory capital requirements.

The test to be employed would be one chosen by the bank, subject to supervisory review.

The test to be employed must be meaningful and reasonably conservative.

Individual banks may develop different approaches to undertaking this stress test requirement, depending on their circumstances.

For this purpose, the objective is not to require banks to consider worst-case scenarios.

The bank’s stress test in this context should, however, consider at least the effect of mild recession scenarios.

In this case, one example might be to use two consecutive quarters of zero growth to assess the effect on the bank’s PDs, LGDs and EADs, taking account — on a conservative basis — of the bank’s international diversification.

435(i) Banks using the double default framework must consider as part of their stress testing framework the impact of a deterioration in the credit quality of protection providers, in particular the impact of protection providers falling outside the eligibility criteria due to rating changes.

Banks should also consider the impact of the default of one but not both of the obligor and protection provider, and the consequent increase in risk and capital requirements at the time of that default.

436. Whatever method is used, the bank must include a consideration of the following sources of information.

First, a bank’s own data should allow estimation of the ratings migration of at least some of its exposures.

Second, banks should consider information about the impact of smaller deterioration in the credit environment on a bank’s ratings, giving some information on the likely effect of bigger, stress circumstances.

Third, banks should evaluate evidence of ratings migration in external ratings.

This would include the bank broadly matching its buckets to rating categories.

437. National supervisors may wish to issue guidance to their banks on how the tests to be used for this purpose should be designed, bearing in mind conditions in their jurisdiction.

The results of the stress test may indicate no difference in the capital calculated under the IRB rules described in this section of this Framework if the bank already uses such an approach for its internal rating purposes.

Where a bank operates in several markets, it does not need to test for such conditions in all of those markets, but a bank should stress portfolios containing the vast majority of its total exposures.

5. Corporate governance and oversight

(i) Corporate governance

438. All material aspects of the rating and estimation processes must be approved by the bank’s board of directors or a designated committee thereof and senior management. *

These parties must possess a general understanding of the bank’s risk rating system and detailed comprehension of its associated management reports.

Senior management must provide notice to the board of directors or a designated committee thereof of material changes or exceptions from established policies that will materially impact the operations of the bank’s rating system.

* This standard refers to a management structure composed of a board of directors and senior management.

The Committee is aware that there are significant differences in legislative and regulatory frameworks across countries as regards the functions of the board of directors and senior management.

In some countries, the board has the main, if not exclusive, function of supervising the executive body (senior management, general management) so as to ensure that the latter fulfils its tasks.

For this reason, in some cases, it is known as a supervisory board.

This means that the board has no executive functions.

In other countries, by contrast, the board has a broader competence in that it lays down the general framework for the management of the bank.

Owing to these differences, the notions of the board of directors and senior management are used in this paper not to identify legal constructs but rather to label two decision-making functions within a bank.

439. Senior management also must have a good understanding of the rating system’s design and operation, and must approve material differences between established procedure and actual practice.

Management must also ensure, on an ongoing basis, that the rating system is operating properly.

Management and staff in the credit control function must meet regularly to discuss the performance of the rating process, areas needing improvement, and the status of efforts to improve previously identified deficiencies.

440. Internal ratings must be an essential part of the reporting to these parties.

Reporting must include risk profile by grade, migration across grades, estimation of the relevant parameters per grade, and comparison of realised default rates (and LGDs and EADs for banks on advanced approaches) against expectations. Reporting frequencies may vary with the significance and type of information and the level of the recipient.

(ii) Credit risk control

441. Banks must have independent credit risk control units that are responsible for the design or selection, implementation and performance of their internal rating systems.

The unit(s) must be functionally independent from the personnel and management functions responsible for originating exposures. Areas of responsibility must include:

• Testing and monitoring internal grades;

• Production and analysis of summary reports from the bank’s rating system, to include historical default data sorted by rating at the time of default and one year prior to default, grade migration analyses, and monitoring of trends in key rating criteria;

• Implementing procedures to verify that rating definitions are consistently applied across departments and geographic areas;

• Reviewing and documenting any changes to the rating process, including the reasons for the changes; and

• Reviewing the rating criteria to evaluate if they remain predictive of risk.

Changes to the rating process, criteria or individual rating parameters must be documented and retained for supervisors to review.

442. A credit risk control unit must actively participate in the development, selection, implementation and validation of rating models. It must assume oversight and supervision responsibilities for any models used in the rating process, and ultimate responsibility for the ongoing review and alterations to rating models.

(iii) Internal and external audit

443. Internal audit or an equally independent function must review at least annually the bank’s rating system and its operations, including the operations of the credit function and the estimation of PDs, LGDs and EADs.

Areas of review include adherence to all applicable minimum requirements.

Internal audit must document its findings.

Some national supervisors may also require an external audit of the bank’s rating assignment process and estimation of loss characteristics.

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 PD88 for each internal borrower grade for corporate, sovereign and bank exposures or for each pool in the case of retail exposures.

* 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 long run 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 own estimates
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. *

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.

* 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.*

• 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. **

• 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.

* In some jurisdictions, specific provisions on equity exposures are set aside for price risk and do not signal default.

** 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 internalrating 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 default weighted 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.

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.

486. The criteria must be plausible and intuitive, and must address the guarantor’s ability and willingness to perform under the guarantee.

The criteria must also address the likely timing of any payments and the degree to which the guarantor’s ability to perform under the guarantee is correlated with the borrower’s ability to repay.

The bank’s criteria must also consider the extent to which residual risk to the borrower remains, for example a currency mismatch between the guarantee and the underlying exposure.

487. In adjusting borrower grades or LGD estimates (or in the case of retail and eligible purchased receivables, the process of allocating exposures to pools), banks must take all relevant available information into account.

Credit derivatives

488. The minimum requirements for guarantees are relevant also for single-name credit derivatives.

Additional considerations arise in respect of asset mismatches.

The criteria used for assigning adjusted borrower grades or LGD estimates (or pools) for exposures hedged
with credit derivatives must require that the asset on which the protection is based (the reference asset) cannot be different from the underlying asset, unless the conditions outlined in the foundation approach are met.

489. In addition, the criteria must address the payout structure of the credit derivative and conservatively assess the impact this has on the level and timing of recoveries.

The bank must also consider the extent to which other forms of residual risk remain.

For banks using foundation LGD estimates

490. The minimum requirements outlined in paragraphs 480 to 489 apply to banks using the foundation LGD estimates with the following exceptions:

(1) The bank is not able to use an ‘LGD-adjustment’ option; and

(2) The range of eligible guarantees and guarantors is limited to those outlined in paragraph 302.

(x) Requirements specific to estimating PD and LGD (or EL) for qualifying purchased receivables

491. The following minimum requirements for risk quantification must be satisfied for any purchased receivables (corporate or retail) making use of the top-down treatment of default risk and/or the IRB treatments of dilution risk.

492. The purchasing bank will be required to group the receivables into sufficiently homogeneous pools so that accurate and consistent estimates of PD and LGD (or EL) for default losses and EL estimates of dilution losses can be determined.

In general, the risk bucketing process will reflect the seller’s underwriting practices and the heterogeneity of its
customers.

In addition, methods and data for estimating PD, LGD, and EL must comply with the existing risk quantification standards for retail exposures.

In particular, quantification should reflect all information available to the purchasing bank regarding the quality of the underlying receivables, including data for similar pools provided by the seller, by the purchasing bank, or by external sources.

The purchasing bank must determine whether the data provided by the seller are consistent with expectations agreed upon by both parties concerning, for example, the type, volume and on-going quality of receivables purchased.

Where this is not the case, the purchasing bank is expected to obtain and rely upon more relevant data.

Read more about our Certified Basel ii Professional (CBiiPro) program

Read more about our Certified Pillar 2 Expert (CP2E) program

Read more about our Certified Pillar 3 Expert (CP3E) program