cra overview

NEW CRA MODEL: OVERVIEW

CREDIT RISK MANAGEMENT DEPT.

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NEW CREDIT RISK ASSESSMENT (CRA) MODELS

AN OVERVIEW

Background A review of Credit Risk assessment (CRA) Models for Non-Trading & Trading

Sectors was undertaken with the objective of making them Basel-II compliant and

meeting the requirements of Internal Ratings Based (IRB) Approach. The New

CRA Models are being released for Bank-wide implementation.

2. Salient Features of New CRA Models

(a) Type of Models S. No.

Exposure Level (FB + NFB Limits )

Non – Trading Sector (C&I , SSI , AGL)

Trading Sector ( Trade & Services)

(i) Over Rs. 5.00 crore Regular Model Regular Model

(ii) Rs 0.25 crore to Rs. 5.00 crore Simplified Model Simplified Model (b) Type of Ratings

S. No. Model Type of Rating

(i) Regular Model (i) Borrower Rating (ii) Facility Rating

(ii) Simplified Model Borrower Rating (c) Type of Risks Covered : (i) Borrower Rating

Maximum Score

Regular Model Simplified Model

S. No.

Risk Category

Existing Company

New Company

Existing Company

New Company

(i) Financial Risk (FR) 65 25 (65 x 0.39)

70 35 (70/2)

(ii) Qualitative Factors (-‘ve) (-10) (-10) (-10) (-10)

(iii) Business & Industry Risk (BR & IR) /Business Risk (for Trading Sector)

20 30 (20 x 1.5)

20 40 (20 x 2)

(iv) Management Risk (MR) 15 45 ( 15 x 3)

10 25 ( 10 x 2.5)

(v) Qualitative Parameter (External Rating)

(+5) (+5) (+5) (+ 5)

Total 100 100 100 100

(vi) Borrower Rating based on the above Score

(vii) Country Risk (CR)

(viii) Final Borrower Rating after CR

(ix) Financial Statement Quality Excellent/Good/Satisfactory/Poor

(x) Risk Score/Rating Transition Matrix

Comments on Trend in Rating



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(ii) Facility Rating (Regular Model)

# No Scoring under these two parameters for AGL & Trade Segments due to non-

availability of relevant LGD Data; Score out of 92 to be normalised to 100 for these

segments.

@ Marks linked to Borrower Rating Score of the Unit.

S. No. Parameter Maximum Score

(a) Risk Drivers for Loss Given Default (LGD)

(i) Current Ratio [Working Capital/ Non-Fund

Based Facility (except Capex)] Or Project

Debt/Equity[Term Loan/Non-Fund Based

Facility (for Capex)]

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(ii) Nature of Charge

4

(iii) Industry /(Trade- for Trading Sector) #

6

(iv) Geography #

2

(v) Unit Characteristics (a) Leverage/ Enforcement of Collateral-4 (b) Safety, Value & Existence of Assets-4

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(vi) Macro-Economic Conditions (a) GDP Growth Rate : Impact of Business

Cycle - 2 (b) Insolvency Legislation in the Jurisdiction-1 (c) Impact of Systemic/Legal Factors on

Recovery-1 (d) Time Period for Recovery-1

5

(vii) Total Security (Primary + Collateral)

60

(b) Risk Drivers for Exposure at Default (EAD)

(i) Nature of Commitment (Revolving/Non-Revolving)

1

(ii) Credit Quality of Borrower @

5

(iii) Tenor of Facility 3 Total Score 100

Facility Rating based on the above Score



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(d) New Rating Scales - Borrower Rating: 16 Rating Grades

(e) New Rating Scales - Facility Rating (Separate for each Fund Based / Non- Fund Based Facility): 16 Rating Grades

S. No.

Borrower Rating

Range of Scores

Risk Level Comfort Level

1 SB1 94-100 Virtually Zero risk Virtually Absolute safety

2 SB2 90-93 Lowest Risk Highest safety

3 SB3 86-89 Lower Risk Higher safety

4 SB4 81-85 Low Risk High safety

5 SB5 76-80 Moderate Risk with Adequate Cushion

Adequate safety

6 SB6 70-75

7 SB7 64-69

Moderate Risk

Moderate Safety

8 SB8 57-63

9 SB9 50-56

Average Risk Above Safety Threshold

10 SB10 45-49 Acceptable Risk (Risk Tolerance Threshold)

Safety Threshold

11 SB11 40-44 Borderline risk Inadequate safety

12 SB12 35-39 High Risk Low safety

13 SB13 30-34 Higher Risk Lower safety

14 SB14 25-29 Substantial risk Lowest safety

15 SB15 <24 Pre-Default Risk (extremely vulnerable to default)

16 SB16 - Default Grade

Nil

S NO

FACILITY GRADES

RANGE OF SCORES

LGD LEVEL (Recovery Level)

RISK LEVEL COMFORT LEVEL

1 FR1 94-100 Virtually Zero LGD Virtually Zero Risk Virtually Absolute Safety

2 FR2 87-93 Lowest LGD (Highest Recovery)

Lowest Risk Highest Safety

3 FR3 80-86 Lower LGD (Higher Recovery)

Lower Risk Higher Safety

4 FR4 73-79 Very Low LGD (High Recovery)

Low Risk High Safety

5 FR5 66-72 Low LGD (Adequate Recovery)

Moderate Risk with Adequate Cushion

Adequate Safety

6 FR6 59-65 7 FR7 52-58

Moderate LGD (Moderate recovery)

Moderate Risk

Moderate Safety

8 FR8 45-51

9 FR9 38-44

Average LGD (Average Recovery)

Average Risk Above Safety Threshold

10

FR10

31-37

LGD Tolerance Threshold (Recovery Tolerance

Threshold)

Acceptable Risk (Risk Tolerance Threshold)

Safety Threshold

11 FR11 24-30 High LGD (Low recovery) High Risk Low Safety

12 FR12 17-23

Higher LGD (Lower Recovery)

Higher Risk Lower Safety

13 FR13 11-16 14 FR14 5-10

Substantial LGD (Small recovery)

Substantial Risk Lowest Safety

15 FR15 1-4

16 FR16 0

Highest LGD (Minimal/zero recovery

Highest Risk NIL



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(f) Mapping to Existing Borrower Rating Bands

New CRA Model Existing CRA Model S. No.

Score Grade Grade Score

1 94-100 SB1

2 90-93 SB2

SB1 >= 90

3 86-89 SB3

4 81-85 SB4

5 76-80 SB5

SB2

>=75

6 70-75 SB6

7 64-69 SB7

SB3

>=65

8 57-63 SB8

9 50-56 SB9

SB4 >=50

10 45-49 SB10 SB5 >=45

11 40-44 SB11

12 35-39 SB12

SB6 >35

13 30-34 SB13

14 25-29 SB14

SB7 >=25

15 < 24 SB15 SB8 <25

16 - SB16

(g) Qualitative Parameter (External Rating)

Solicited Rating by a recognized External Credit Rating Agency (ECRA) translates to

additional Score. Following ECRAs recognised by RBI are considered for this

purpose:

. S. No. Type ECRA

1 Domestic

(a) Credit Analysis & Research Limited;

(b) CRISIL Limited;

(c) FITCH India;

(d) (d) ICRA Limited.

2 International

(a) FITCH;

(b) Moodys;

(c) Standard & Poor’s

RBI has clarified that “Cash Credit Exposures tend to be generally rolled over and

also tend to be drawn on an average for a major portion of the sanctioned limits.

Hence even though a cash credit exposure may be sanctioned for a period of one

year or less, these exposures should be reckoned as Long Term Exposures and

accordingly, the Long Term Ratings accorded by the chosen Credit Rating Agencies



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will be relevant.” The Scoring Bands for factoring External Rating (Long Term/Short

Term) are as under:

Short Term Rating Long

Term

Rating

CARE CRISIL FITCH ICRA

Standardised

Approach

Risk Weight

Additional Score

Under New

CRA Models

AAA PR1+ P1+ F1+ A1+ 20% 5

AA PR1 P1 F1 A1 30% 3.5

A PR2 P2 F2 A2 50% 2

BBB PR3 P3 F3 A3 100% 1

BB &

below

PR4

& PR5

P4 &

P5

B,C,D A 4/

A 5

150%

0

Multiple Ratings: In case of borrowers having multiple ratings from recognised ECRAs, following

procedure is to be followed:

(i) If there is only one ECRA rating for a particular claim, that rating would be

used to determine scoring;

(ii) If there are two ratings accorded by ECRAs which map into different risk

weights, the rating corresponding to the higher risk weight would be taken

cognisance of for scoring ;

(iii) If there are three or more ratings accorded by ECRAs, with different risk

weights, the ratings corresponding to the two lowest risk weights should be

referred to and the rating corresponding to the higher of the two risk

weights should be taken cognisance of for scoring.

(h) Financial Statement Quality The credit analyst is to comment on the quality, adequacy and reliability of financial

statements/information irrespective of the Risk Rating. This includes consideration

of the size and capabilities of the accounting firm, compared to the complexities of

the borrower and its financial statements. The comments on the quality of financial

statements should include the quality of information provided to the Bank. The

Quality is to be indicated as Excellent/Good/Satisfactory/Poor. This step is not



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instrumental in improvement of rating but is helpful in defining the best possible

Borrower Rating.

(i) Risk Score /Rating Transition Matrix

A major fluctuation in scores resulting in upgradation or deterioration in Rating by

more than one stage, is to be commented upon. Upgradation in Rating only on

account of higher score in parameters other than Financial Risk , is to be examined

and commented upon. This provides an additional risk awareness tool for the Credit

Analyst.

(j) Country Risk (Applicable for borrowers having 25% or more cashflow or assets

outside India)

Country risk is the risk that a borrower will not be able to service its obligations to

pay because of cross-border restrictions on the convertibility or availability of a

given currency. It is also an assessment of the political and economic risk of a

country. Country Risk is assumed to exist when 25% or more of the borrower’s

cashflow or assets are located outside India. Country Risk Ratings are circulated by

Foreign Department (FD). Last FD Circular No. 070/2007-08 dated 27th July, 2007

indicates Risk category-wise list of countries as on 31/03/2007.

(k) Entry Barriers

(i) Minimum Score ‘2’ under ‘Integrity ‘ parameter under ‘Management Risk’ ;

(ii) Full Compliance with Environmental Regulations

(l) Hurdle Scores

Regular Model Simplified Model Risk Types Existing

Company New Company

Existing Company

New Company

Financial Risk (FR)

25/65 10/25 30/70 15/35

Business & Industry Risk (B&IR) [Business Risk (BR) for trade]

12/20 16/30 10/20 20/40

Management Risk (MR)

8/15 22/45 5/10 13/25

Aggregate hurdle Score

45/100 48/100 45/100 48/100

Overall Hurdle Grade# SB10 SB10 SB10 SB10

# Score Range 45-49 corresponds to SB10. Hence as per New CRA Models SB10 is

the new Hurdle Grade.



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Under Facility Rating, if the score goes below the hurdle rate of FR10, the reasons

for low score are to be given.

(m) Factoring Decimal Scores while aggregating Score for Risk Grading

(i) Score upto 0. 4 to be ignored;

(ii) Score of 0.5 or more to be rounded off to the next number.

(n) Reporting of Risk Score alongwith Rating:

Aggregate Risk Score is to be shown in brackets alongwith Borrower Rating in

internal reporting within the Bank.

(o) Frequency of Rating: Annual (p) Risk Assessment for New Units

Activity Status Basis of Risk Assessment

Newly incorporated unit where the production/commercial production is yet to begin

Projected Financials

Newly incorporated unit where the audited financials relate to less than 12 months of commercial production.

Projected Financials

Newly incorporated unit where the audited financials reflect minimum 12 months of working after the start of commercial production.

Audited Financials

For Rating purpose, a new unit refers to a newly incorporated Firm/Company

which may continue to be regarded as new for a period of three years after the

start of commercial production. However, in the case of Companies/Firms

promoted by an established Group, a view regarding their status as new or

otherwise would be taken by the CGM of the Circle/CAG/Mid-Corporate after

one year’s performance.

(q) General

(i) For units engaged in both ‘industrial’ & ‘trading’ activities, the Risk Rating

will be done based on the predominant activity financed by the Bank and the

relevant model used.

(ii) If data on a certain industry for ‘industry comparison’ in CRIS-INFAC or

CMIE or any other published source is not available, the score would be

normalised. In a Multi Division Company, the thrust of scoring under



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‘Industry Outlook’ would be limited to the industry being financed by the

Bank.

(iii) Wherever a parameter is not applicable, the score would be normalised.

(iv) For a new unit, where value statements for some of the parameters appear to

be out of place for scoring, the Credit Analyst would assess whether the unit

has any plans to measure upto the levels indicated under those value

statements and then score accordingly.

(v) While Borrower Rating of a unit will remain unchanged for a period upto one

year, the different facilities would be rated simultaneously with Borrower

Rating or as and when the facility is sanctioned/reappraised. A unit would

carry several different Facility Ratings e.g. if a unit is enjoying one Working

Capital facility & two (say) Term Loan facilities, it will have one Borrower

Rating & 3 Facility Ratings.

(vi) Borrower Rating would not be assessed each time a new facility is sanctioned

to the unit within the year.

(vii) While working out the Facility Rating, the share of total security against that

facility will be worked out to score under Total Security (Primary +

Collateral).

3. Facility Rating (i) Facility Rating Design

A Borrowing Company may be availing either one or more of Fund Based (FB)

Facilities such as Working Capital (WC) /Term Loan (TL) or/and Non-Fund Based

(NFB) Facilities like, Letters of Credit (L C)/Bank Guarantee (BG). All the facilities

are to be rated separately viz., if a Borrowing Company has both WC & TL & two

Bank Guarantee Facilities & three different L/C Facilities; in total, the Company

would have one Borrower Rating & seven (i.e, 1+1+2 + 3 = 7) Facility Ratings.

The pricing of loans, in future, will be linked to Facility Rating after building up

adequate Loss Given Default (LGD) data base. For the present, pricing will

continue to be linked to Borrower Rating only.



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(ii) Facility Hurdle Rate All facilities are expected to meet the Facility Hurdle Rate of FR10. Reasons for not

crossing this Hurdle Rate would need to be commented upon by the Credit

Analyst.

(iii) Loss Given Default (LGD) Facility Rating would reflect the degree of severity of loss in the event of default on

the obligation. Facility Rating Grade will thus translate to a LGD Scale, indicating

loss percentage. The present Facility Rating Grades/Scales are empirically

designed to reflect LGD levels.

(iv) Collateral

The Collaterals are an important ingredient of Facility Rating design; their quality

and depth affects the severity of LGD for any facility and hence the Facility Rating

itself. As an element of risk (uncertainty) is involved, prudence is required in

assessing the value of the collateral offered for obtaining credit facility. The security

is thus to be valued as it would be in a distress scenario i.e, the extent of availability

of proceeds (legal certainty) in the event of failure of the business.

Basel-II does not differentiate between Primary & Collateral Securities and all

securities charged for a loan are designated as “Collaterals”. Thus, while for

monitoring of Drawing Power (DP) or DP related issues in borrowal accounts, the

securities charged would continue to be segregated into Primary and Collateral

securities, however, for the purpose of risk assessment, all securities will be treated as

collateral securities.

(v) Scoring under Facility Rating Scoring under ‘Total Security ‘Parameter under Facility Rating requires an in-depth

look into types of Collaterals & Guarantees and their recognition and valuation as

per Basel-II /RBI Document as discussed in Bank’s Collateral Management Policy

(please see para 5 below). This would necessitate detailed analysis of

Collaterals/Guarantees to facilitate scoring.



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4. IRB Requirements under Basel-II Guidelines Requirements for Risk Rating Design under Internal Ratings Based (IRB) Approach

are detailed in Basel-II Document (International Convergence of Capital

Measurement and Capital Standards) published in June, 2004, available on the

Bank for International Settlement website www.bis.org. Extracts from the

Document are enclosed (for reference and detailed study, if desired).

The following definitions are used in this context:

S. No. Terminology Definition

(i) Probability of

Default (PD)

The probability/risk/chance of a borrower defaulting

on the payment of the credit obligations.

(ii) Loss Given

Default (LGD)

The loss suffered in the event of a default of an

exposure.

(iii) Exposure at

Default (EAD)

The amount that is exposed to the default risk.

(iv) Expected Loss

(EL)

Part of the credit loss that happens in the normal course

of business due to default of exposures and the banks

have to either make provisions for it or price it in the

loans.

(v) Unexpected

Loss (UL)

Part of credit loss that cannot be estimated or priced into

the product and hence the banks have to provide capital

for it by risk-weighting their assets.

Highlights of Basel requirements are as under:

(i) The term “rating system” comprises all of the methods, processes, controls,

and data collection and IT systems that support the assessment of credit risk,

the assignment of internal risk ratings, and the quantification of default and

loss estimates.

(ii) A qualifying IRB rating system needs to have two separate and distinct

dimensions: (a) the risk of borrower default i.e, Borrower Rating and (b)

transaction-specific factors i.e., Facility Rating.



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(iii) A bank must articulate the relationship between borrower grades in terms of

the level of risk each grade implies. Perceived and measured risk must

increase as credit quality declines from one grade to the next.

(iv) The second dimension must reflect transaction-specific factors, such as

collateral, seniority, product type, etc. For banks using the advanced

approach, facility ratings must reflect exclusively Loss Given Default (LGD).

These ratings can reflect any and all factors that can influence LGD

including, but not limited to, the type of collateral, product, industry, and

purpose. Borrower characteristics may be included as LGD rating criteria

only to the extent they are predictive of LGD. Banks may alter the factors

that influence facility grades across segments of the portfolio as long as they

can satisfy their supervisor that it improves the relevance and precision of

their estimates.

(v) A bank must have a meaningful distribution of exposures across grades with

no excessive concentrations, on both its borrower-rating and its facility-

rating scales. To meet this objective, a bank must have a minimum of seven

borrower grades for non-defaulted borrowers and one for those that have

defaulted. Banks with lending activities focused on a particular market segment

may satisfy this requirement with the minimum number of grades; supervisors may

require banks, which lend to borrowers of diverse credit quality, to have a greater

number of borrower grades.

(vi) There is no specific minimum number of facility grades for banks using the

advanced approach for estimating LGD. A bank must have a sufficient

number of facility grades to avoid grouping facilities with widely varying

LGDs into a single grade. The criteria used to define facility grades must be

grounded in empirical evidence.

(vii) A bank must have specific rating definitions, processes and criteria for

assigning exposures to grades within a rating system. The rating definitions

and criteria must be both plausible and intuitive and must result in a

meaningful differentiation of risk.



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(vii) To ensure that banks are consistently taking into account available

information, they must use all relevant and material information in

assigning ratings to borrowers and facilities. Information must be current.

The less information a bank has, the more conservative must be its

assignments of exposures to borrower and facility grades or pools. An

external rating can be the primary factor determining an internal rating

assignment; however, the bank must ensure that it considers other relevant

information.

(viii) A borrower rating must represent the bank’s assessment of the borrower’s

ability and willingness to contractually perform despite adverse economic

conditions or the occurrence of unexpected events. The range of economic

conditions that are considered when making assessments must be consistent

with current conditions and those that are likely to occur over a business

cycle within the respective industry/geographic region.

(ix) Given the difficulties in forecasting future events and the influence they will

have on a particular borrower’s financial condition, a bank must take a

conservative view of projected information. Furthermore, where limited

data are available, a bank must adopt a conservative bias to its analysis.

(x) A bank must have a credible track record in the use of internal ratings

information. 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.

5. Collaterals & Guarantees Collateral Management Policy of the Bank has been put in place based on Basel-II

/RBI Guidelines, vide Circular No. CPP/NJ/CIR/58 dated 21st September, 2007.

This Policy is to be referred to for scoring under ‘Total Security’ Parameter under

Facility Rating.



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Some features of the Policy are mentioned below:

• In addition to the general requirements for legal certainty, the legal mechanism by

which the collateral is pledged or transferred must ensure that the Bank has the

right to liquidate or take legal possession of the Collateral, in a timely manner, in

the event of the default/insolvency /bankruptcy on the part of the counterparty

or third party.

• Collaterals are broadly classified as Financial and Non-Financial

• A guarantee (counter-guarantee) must represent a direct claim on the protection

provider and must be explicitly referenced to specific exposures or a pool of

exposures, so that the extent of the cover is clearly defined and incontrovertible.

The guarantee must be irrevocable. There must be no clause in the contract that

would allow the protection provider unilaterally to cancel the cover or that

would increase the effective cost of cover as a result of deteriorating credit

quality in the guaranteed exposure.

• The guarantee must also be unconditional; there should be no clause in the

guarantee outside the direct control of the Bank that could prevent the protection

provider from being obliged to pay out in a timely manner in the event that the

original counterparty fails to make the payment(s) due.

6. Details of New CRA Models

Details of New CRA Models are enclosed, separately, for Non-Trading & Trading Sectors.



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RATING SYSTEM DESIGN AS PER INTERNAL RATINGS BASED (IRB)

APPROACH UNDER BASEL-II

Extracts from Basel-II Document (International Convergence of Capital

Measurement and Capital Standards, June, 2004-Bank for International

Settlement website: www.bis.org)

Rating System Design

(Para Number)

394. The term “rating system” comprises all of the methods, processes, controls,

and data collection and IT systems that support the assessment of credit risk,

the assignment of internal risk ratings, and the quantification of default and

loss estimates.

395. Within each asset class, a bank may utilise multiple rating methodologies/

systems. For example, a bank may have customised rating systems for

specific industries or market segments (e.g. middle market, and large

corporate). If a bank chooses to use multiple systems, the rationale for

assigning a borrower to a rating system must be documented and applied in

a manner that best reflects the level of risk of the borrower. Banks must not

allocate borrowers across rating systems inappropriately to minimize

regulatory capital requirements (i.e. cherry-picking by choice of rating

system). Banks must demonstrate that each system used for IRB purposes is

in compliance with the minimum requirements at the outset and on an

ongoing basis.

(i) Rating Dimensions :

Standards for Corporate, Sovereign, and Bank Exposures

396. A qualifying IRB rating system must have two separate and distinct

dimensions:

(i) the risk of borrower default, and

(ii) transaction-specific factors.

397. The first dimension must be oriented to the risk of borrower default. Separate

exposures to the same borrower must be assigned to the same borrower grade,



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irrespective of any differences in the nature of each specific transaction. There are

two exceptions to this. Banks are not required to produce their own

estimates of PD for certain equity exposures and certain exposures that fall

within the Specialised Lending (SL) sub-class. Firstly, in the case of country

transfer risk, where a bank may assign different borrower grades depending

on whether the facility is denominated in local or foreign currency.

Secondly, when the treatment of associated guarantees to a facility may be

reflected in an adjusted borrower grade. In either case, separate exposures

may result in multiple grades for the same borrower. A bank must articulate

in its credit policy the relationship between borrower grades in terms of the

level of risk each grade implies. Perceived and measured risk must increase

as credit quality declines from one grade to the next. The policy must

articulate the risk of each grade in terms of both a description of the

probability of default risk typical for borrowers assigned the grade and the

criteria used to distinguish that level of credit risk.

398. The second dimension must reflect transaction-specific factors, such as

collateral, seniority, product type, etc. For foundation IRB banks, this

requirement can be fulfilled by the existence of a facility dimension, which

reflects both borrower and transaction-specific factors. For example, a

rating dimension that reflects EL by incorporating both borrower strength

(PD) and loss severity (LGD) considerations would qualify. Likewise a

rating system that exclusively reflects LGD would qualify. Where a rating

dimension reflects EL and does not separately quantify LGD, the

supervisory estimates of LGD must be used.

399. For banks using the advanced approach, facility ratings must reflect

exclusively LGD. These ratings can reflect any and all factors that can

influence LGD including, but not limited to, the type of collateral, product,

industry, and purpose. Borrower characteristics may be included as LGD

rating criteria only to the extent they are predictive of LGD. Banks may

alter the factors that influence facility grades across segments of the ortfolio

as long as they can satisfy their supervisor that it improves the relevance

and precision of their estimates.

400. Banks using the supervisory slotting criteria for the SL sub-class are exempt



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from this two-dimensional requirement for these exposures. Given the

interdependence between borrower/transaction characteristics in SL, banks

may satisfy the requirements under this heading through a single rating

dimension that reflects EL by incorporating both borrower strength (PD)

and loss severity (LGD) considerations. This exemption does not apply to

banks using either the general corporate foundation or advanced approach

for the SL subclass.

(ii) Rating Structure : Standards for Corporate, Sovereign, and Bank Exposures

403. A bank must have a meaningful distribution of exposures across grades with

no excessive concentrations, on both its borrower-rating and its facility-

rating scales.

404. To meet this objective, a bank must have a minimum of seven borrower

grades for non-defaulted borrowers and one for those that have defaulted.

Banks with lending activities focused on a particular market segment may

satisfy this requirement with the minimum number of grades; supervisors

may require banks, which lend to borrowers of diverse credit quality, to

have a greater number of borrower grades.

405. A borrower grade is defined as an assessment of borrower risk on the basis

of a specified and distinct set of rating criteria, from which estimates of PD

are derived. The grade definition must include both a description of the

degree of default risk typical for borrowers assigned the grade and the

criteria used to distinguish that level of credit risk. Furthermore,“+” or “-”

modifiers to alpha or numeric grades will only qualify as distinct grades if

the bank has developed complete rating descriptions and criteria for their

assignment, and separately quantifies PDs for these modified grades.

406. Banks with loan portfolios concentrated in a particular market segment and

range of default risk must have enough grades within that range to avoid

undue concentrations of borrowers in particular grades. Significant

concentrations within a single grade or grades must be supported by

convincing empirical evidence that the grade or grades cover reasonably



17

narrow PD bands and that the default risk posed by all borrowers in a grade

fall within that band.

407. There is no specific minimum number of facility grades for banks using the

advanced approach for estimating LGD. A bank must have a sufficient

number of facility grades to avoid grouping facilities with widely varying

LGDs into a single grade. The criteria used to define facility grades must be

grounded in empirical evidence.

408. Banks using the supervisory slotting criteria for the SL asset classes must

have at least four grades for non-defaulted borrowers, and one for defaulted

borrowers. The requirements for SL exposures that qualify for the corporate

foundation and advanced approaches are the same as those for general

corporate exposures.

(iii) Rating Criteria 410. A bank must have specific rating definitions, processes and criteria for

assigning exposures to grades within a rating system. The rating definitions

and criteria must be both plausible and intuitive and must result in a

meaningful differentiation of risk.

• The grade descriptions and criteria must be sufficiently detailed to allow

those charged with assigning ratings to consistently assign the same grade to

borrowersor facilities posing similar risk. This consistency should exist

across lines of business, departments and geographic locations. If rating

criteria and procedures differ for different types of borrowers or facilities,

the bank must monitor for possibleinconsistency, and must alter rating

criteria to improve consistency when appropriate.

• Written rating definitions must be clear and detailed enough to allow third

parties to understand the assignment of ratings, such as internal audit or an

equally independent function and supervisors, to replicate rating

assignments and evaluate the appropriateness of the grade/pool

assignments. The criteria must also be consistent with the bank’s internal

lending standards and its policies for handling troubled borrowers and



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facilities.

411. To ensure that banks are consistently taking into account available

information, they must use all relevant and material information in

assigning ratings to borrowers and facilities. Information must be current.

The less information a bank has, the more conservative must be its

assignments of exposures to borrower and facility grades or pools. An

external rating can be the primary factor determining an internal rating

assignment; however, the bank must ensure that it considers other relevant

information.

(iv) Rating Assignment Horizon 414. Although the time horizon used in PD estimation is one year, banks are

expected to use a longer time horizon in assigning ratings.

415. A borrower rating must represent the bank’s assessment of the borrower’s

ability and willingness to contractually perform despite adverse economic

conditions or the occurrence of unexpected events. For example, a bank may

base rating assignments on specific, appropriate stress scenarios.

Alternatively, a bank may take into account borrower characteristics that are

reflective of the borrower’s vulnerability to adverse economic conditions or

unexpected events, without explicitly specifying a stress scenario. The range

of economic conditions that are considered when making assessments must

be consistent with current conditions and those that are likely to occur over

a business cycle within the respective industry/geographic region.

416. Given the difficulties in forecasting future events and the influence they will

have on a particular borrower’s financial condition, a bank must take a

conservative view of projected information. Furthermore, where limited

data are available, a bank must adopt a conservative bias to its analysis.

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



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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.

Definition of Default for PD Estimation as per Basel-II Document

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.

453. The elements to be taken as indications of unlikeliness to pay include:

• The bank puts the credit obligation on non-accrued status.



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• 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 credi-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.

Requirements specific to PD estimation 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



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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 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 set in the document.

Requirements specific to own-LGD Estimates 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.

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



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provider. Cases where there is a significant degree of dependence must be

addressed in a conservative manner.

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. His requirement recognises the potential inability of banks to gain

both control of their collateral and liquidate it expeditiously.

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.

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.

Requirements specific to own-EAD Estimates 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. 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.

475. Advanced approach banks must assign an estimate of EAD for each facility.

It must be an estimate of he long-run default-weighted average EAD for



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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.

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. Across facility types, a bank must review is estimates of EAD when

material new information comes to light and a least on an annual basis.

477. 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.

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.

Guarantees 480. When a bank uses is 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.

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.

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.



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507. Definition of Eligibility of Commercial Real Estate (CRE) and Residential Real Estate (RRE) Collateral

• Collateral where the risk of the borrower is not materially dependent upon

the performance of the underlying property or project, but rather on the

underlying capacity of the borrower to repay the debt from other sources. As

such, repayment of the facility is not materially dependent on any cash flow

generated by the underlying CRE/RRE serving as collateral; and

• Additionally, the value of the collateral pledged must not be materially

dependent on the performance of the borrower.

509. Operational requirements for Eligible CRE/RRE

• Legal enforceability: Any claim on a collateral taken must be legally

enforceable in all relevant jurisdictions, and any claim on collateral must be

properly filed on a timely basis. Collateral interests must reflect a perfected

lien (i.e. all legal requirements for establishing the claim have been fulfilled).

Furthermore, the collateral agreement and the legal process underpinning it

must be such that they provide for the bank to realise the value of the

collateral within a reasonable timeframe.

• Objective market value of collateral : The collateral must be valued at or

less than the current fair value under which the property could be sold under

private contract between a willing seller and an arm’s-length buyer on the

date of valuation.

• Frequent revaluation: The bank is expected to monitor the value of the

collateral on a frequent basis and at a minimum once every year. More

frequent monitoring is suggested where the market is subject to significant

changes in conditions.

510. Additional collateral management requirements are as follows:

• The types of CRE and RRE collateral accepted by the bank and lending

policies (advance rates) when this type of collateral is taken must be clearly

documented.



25

• The bank must take steps to ensure that the property taken as collateral is

adequately insured against damage or deterioration.

• The bank must monitor on an ongoing basis the extent of any permissible

prior claims (e.g. tax) on the property.

• The bank must appropriately monitor the risk of environmental liability

arising in respect of the collateral, such as the presence of toxic material on a

property.

511. Requirements for recognition of financial receivables Definition:

Eligible financial receivables are claims with an original maturity of less than or

equal to one year where repayment will occur through the commercial or

financial flows related to the underlying assets of the borrower.

521. Requirements for recognition of other collateral Supervisors may allow for recognition of the credit risk mitigating effect of

certain other physical collateral. Each supervisor will determine which, if any,

collateral types in its jurisdiction meet the following two standards:

• Existence of liquid markets for disposal of collateral in an expeditious and

economically efficient manner.

• Existence of well established, publicly available market prices for the

collateral. Supervisors will seek to ensure that the amount a bank receives

when collateral is realised does not deviate significantly from these market

prices.

522. In order for a given bank to receive recognition for additional physical

collateral, it must meet all the standards in paragraphs 509 and 510, subject

to the following modifications.



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• First Claim : only first liens on, or charges over, collateral are permissible. As

such, the bank must have priority over all other lenders to the realised

proceeds of the collateral.

• The loan agreement must include detailed descriptions of the collateral plus

detailed specifications of the manner and frequency of revaluation.

• The types of physical collateral accepted by the bank and policies and practices

in respect of the appropriate amount of each type of collateral relative to the

exposure amount must be clearly documented in internal credit policies and

procedures and available for examination and/or audit review.

• Bank credit policies with regard to the transaction structure must address

appropriate collateral requirements relative to the exposure amount, the ability

to liquidate the collateral readily, the ability to establish objectively a price or

market value, the frequency with which the value can readily be obtained

(including a professional appraisal or valuation), and the volatility of the value

of the collateral. The periodic revaluation process must pay particular attention

to “fashion-sensitive” collateral to ensure that valuations are appropriately

adjusted downward of fashion, or model-year, obsolescence as well as physical

obsolescence or deterioration.

• In cases of inventories (e.g. raw materials, work-in-process, finished goods,

dealers’ inventories of autos) and equipment, the periodic revaluation process

must include physical inspection of the collateral.

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