1. Introduction
1.1 Terminology
1.1.1 Abbreviations and other terms used in this paper have the following meanings:
• “PD” means the probability of default of a counterparty over one year.
• “LGD” means the loss incurred on a facility upon default of a counterparty relative to the amount outstanding at default.
• “EAD” means the expected gross exposure of a facility upon default of a counterparty.
• “Dilution risk” means the possibility that the amount of a receivable is reduced through cash or non-cash credits to the receivables obligor.
• “EL” means the expected loss on a facility arising from the potential default of a counterparty or the dilution risk relative to EAD over one year “IRB Approach” means Internal Ratings-based Approach.
• “SL” means Specialized lending.
• “Foundation IRB Approach” means that, in applying the IRB framework, banks provide their own estimates of PD and use supervisory estimates of LGD and EAD, and, unless otherwise specified by the SAMA, are not required to take into account the effective maturity of credit facilities.
• “Advanced IRB Approach,” means that, in applying the IRB framework, banks use their own estimates of PD, LGD and EAD, and are required to take into account the effective maturity of credit facilities. A “borrower grade” means a category of creditworthiness to which borrowers are assigned based on a specified and distinct set of rating criteria, from which estimates of PD are derived. The grade definition includes 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.
• A “facility grade” means a category of loss severity in the event of default (as measured by LGD or EL) to which transactions are assigned on the basis of a specified and distinct set of rating criteria. The grade definition involves assessing the amount of collateral, and reviewing the term and structure of the transaction (such as the lending purpose, repayment structure and seniority of claims).
• A “rating system” means 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. Key aspects of a rating system are summarized in Table 1.
• “Seasoning” means an expected change of risk parameters over the life of a credit exposure.
1.2 Application
1.2.1 The requirements set out in this paper are applicable to locally incorporated banks, which use or intend to use the IRB Approach to measure capital charges for credit risk.
1.2.2 In the case of branches of foreign banks, all or part of their IRB systems may be centrally developed and monitored on a group basis. In applying the requirements of this paper, the SAMA will consider the extent to which reliance can be placed on the work done at the group level. Where necessary, SAMA will co-ordinate with the home supervisors of those banks regarding the assessment of the comprehensiveness and integrity of the group-wide internal rating systems adopted by their branches in Saudi Arabia. SAMA will also assess whether the relevant systems or models can adequately reflect the specific risk characteristics of the banks’ domestic portfolios.
1.3 Background and Scope
1.3.1 The IRB Approach to the measurement of credit risk for capital adequacy purposes relies on banks’ internally generated inputs to the calculation of capital. To minimize variation in the way in which the IRB Approach is carried out and to ensure significant comparability across banks, the SAMA considers it necessary to establish minimum qualifying criteria regarding the comprehensiveness and integrity of the internal rating systems of banks adopting the IRB Approach. The SAMA will employ these criteria for assessing their eligibility to use the IRB Approach.
1.3.2 This Document:
Prescribes the minimum requirements that a banks internal rating system should comply with at the outset and on an ongoing basis if it were to use the IRB Approach to measure credit risk for capital adequacy purposes; and
Sets out SAMA’s supervisory approach where a bank is not in full compliance with the minimum requirements.
1.3.3 The minimum requirements set out herein apply to both the Foundation IRB Approach, and the Advanced IRB Approach and to all asset classes1, unless stated otherwise. The standards related to the process of assigning exposures to borrower or facility grades and the related oversight, validation, etc. apply equally to the process of assigning retail exposures to pools of homogenous exposures, unless noted otherwise.
1.3.4 The minimum requirements for internal rating systems of equity exposures under the PD/LGD Approach are the same as those of the Foundation IRB Approach for corporate exposures, subject to the specifications set out in the “Risk-weighting Framework for IRB Approach”. Where banks adopt the internal models approach to calculate capital charges for equity exposures, the relevant requirements are set out in the “Minimum Requirements for Risk Quantification under IRB Approach”.
1.3.5 The quantification of default and loss estimates described in this paper should be read in conjunction with the “Minimum Requirements for Risk Quantification under IRB Approach”.
1 Under the IRB Approach, assets are broadly categorized into five classes: (i) corporate (with specialized lending as a subclass); (ii) sovereign; (iii) bank; (iv) retail; and (v) equity.