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  • 4. Rating System Design

    • 4.1 Rating Dimensions

       Corporate, sovereign and bank exposures
       
      4.1.1Banks adopting the IRB Approach should have a two dimensional rating system that provides separate assessment of borrower and transaction characteristics. This approach assures that the assignment of borrower ratings is not influenced by consideration of transaction specific factors.
       
       Borrower rating
       
      4.1.2The first dimension should reflect exclusively the risk of borrower default. Collateral and other facility characteristics should not influence the borrower rating.1 Banks should assess and estimate the default risk of a borrower based on the quantitative and qualitative information regarding the borrower’s creditworthiness (see subsection 4.4 below for risk assessment criteria). Banks should rank and group borrowers into individual grades each associated with an average PD.
       
      4.1.3Separate exposures to the same borrower should be assigned to the same borrower grade, irrespective of any differences in the nature of each specific transaction. Once a borrower has defaulted on any credit obligation <5% threshold> to a bank (or the banking group2 of which it is a part), all of its facilities with that bank (or the banking group of which it is a part) are considered to be in default (see the definition of default in subsection 4.2 of the “Minimum Requirements for Risk Quantification under IRB Approach”).
       
      4.1.4There are two exceptions that may result in multiple grades for the same borrower. First, to reflect country transfer risk3, a bank may assign different borrower grades depending on whether the facility is denominated in local or foreign currency. Second, the treatment of associated guarantees to a facility may be reflected in an adjusted borrower grade.
       
      4.1.5In assigning a borrower to a borrower grade, banks should assess the risk of borrower default over a period of at least one year. However, this does not mean that banks should limit their consideration to outcomes for that borrower that are most likely to occur over the next 12 months. Borrower ratings should take into account all possible adverse events that might increase a borrower’s likelihood of default (see subsection 4.5 below).
       
       Facility rating
       
      4.1.6The second dimension should reflect transaction specific factors (such as collateral, seniority, product type, etc.) that affect the loss severity in the case of borrower default.
       
      4.1.7For banks adopting the Foundation IRB Approach, this requirement can be fulfilled by the existence of a facility dimension which may take the form of: A facility rating system that provides a measure of EL by incorporating both borrower strength (PD) and loss severity (LGD); or an explicit quantifiable LGD rating dimension,
       
       Representing the conditional severity of loss, should default occur, from the credit facilities.
       
       In calculating the regulatory capital requirements, these banks should use the supervisory estimates of LGD.
       
      4.1.8For banks using the Advanced IRB Approach, facility ratings should reflect exclusively LGD. These ratings should cover 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 the SAMA that it improves the relevance and precision of their estimates.
       
      4.1.9Banks using the supervisory slotting criteria for the specialized lending (“SL”) exposures need not apply this two-dimensional requirement to these exposures. Given the interdependence between borrower and transaction characteristics in SL, Banks may instead adopt a single rating dimension that reflects EL by incorporating both borrower strength (PD) and loss severity (LGD) considerations.
       
       Retail exposures
       
      4.1.10Rating systems for retail exposures should reflect both borrower and transaction risks, and capture all relevant borrower and transaction characteristics. Banks should assign each retail exposure to a particular pool. For each pool, banks should estimate PD, LGD and EAD. Multiple pools may share identical PD, LGD and EAD estimates.
       
      4.1.11Banks should demonstrate that this grouping process provides for a meaningful differentiation of risk and results in sufficiently homogeneous pools that allow for accurate and consistent estimation of loss characteristics at the pool level.
       
      4.1.12Banks should have specific criteria for slotting an exposure into a pool. These should cover all factors relevant to the risk analysis. At a minimum, banks should consider the following risk drivers when assigning exposures to a pool:
       
       Borrower risk characteristics (e.g. borrower type, demographics such as age/occupation);
       
       Transaction risk characteristics including product and/or collateral type. One example of split by product type is to group exposures into credit cards, installment loans, revolving credits, residential mortgages, and small business facilities. When grouping exposures by collateral type, consideration should be given to factors such as loan-to-value ratios, seasoning4, guarantees and seniority (first vs. second lien). Banks should explicitly address cross-collateral provisions, where present;
       
       Delinquency status: Banks should separately identify delinquent and non-delinquent exposures.
       

      1 For example, in an eight-grade rating system, where default risk increases with the grade number, a borrower whose financial condition warrants the highest investment grade rating should be rated a 1 even if the bank‘s transactions are unsecured and subordinated to other creditors. Likewise, a defaulted borrower with a transaction fully secured by cash should be rated an 8 (i.e. the defaulted grade) regardless of the remote expectation of loss. 
      2 The banking group covers all entities within the group that are subject to the capital adequacy regime in Saudi Arabia. 
      3 Country transfer risk is the risk that the borrower may not be able to secure foreign currency to service its external debt obligations due to adverse changes in foreign exchange rates or when the country in which it is operating suffers economic, political or social problems.
      4 Seasoning can be a significant element of portfolio risk monitoring, particularly for residential mortgages, which may have a clear time pattern of default rates.

    • 4.2 Rating Structure

       Corporate, sovereign and bank exposures
       
      4.2.1Banks should have a meaningful distribution of exposures across grades with no excessive concentrations, on both borrower-rating and facility-rating scales (also see paragraph 4.2.4). The number of borrower and facility grades used in a rating system should be sufficient to ensure that management can meaningfully differentiate risk in the portfolio. Perceived and measured risk should increase as credit quality declines from one grade to the next.
       
       Borrower rating
       
      4.2.2Rating systems should have a minimum of seven borrower grades for non-defaulted borrowers and one for defaulted borrowers1. While banks with lending activities focused on a particular market segment may satisfy this requirement with the minimum number of grades, bank’s lending to borrowers of diverse credit quality may need to have a greater number of borrower grades.
       
      4.2.3In defining borrower grades, “+” 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.
       
      4.2.4Banks with loan portfolios concentrated on a particular market segment and a range of default risk should have enough grades within that range to avoid undue concentration of borrowers in particular grades2. Significant concentration within a single grade should be supported by convincing empirical evidence that the grade covers a reasonably narrow PD band and that the default risk posed by all borrowers in the grade falls within that band.
       
      4.2.5For banks using the supervisory slotting criteria for SL exposures, the rating system for such exposures should have at least four grades for non-defaulted borrowers and one for defaulted borrowers. SL exposures that qualify as corporate exposures under the Foundation IRB Approach or the Advanced IRB Approach are subject to the same requirements as those for general corporate exposures (i.e. a minimum of seven borrower grades for non-defaulted borrowers and one for defaulted borrowers).
       
       Facility rating
       
      4.2.6There is no minimum number of facility grades. Banks using the Advanced IRB Approach should ensure that the number of facility grades is sufficient to avoid facilities with widely varying LGDs being grouped into a single grade. The criteria used to define facility grades should be grounded in empirical evidence.
       
       Retail exposures
       
      4.2.7The level of differentiation for IRB purposes should ensure that the number of exposures in a given pool is sufficient to allow for meaningful quantification and validation of the loss characteristics at the pool level. There should be a meaningful distribution of borrowers and exposures across pools to avoid undue concentration of a bank’s retail exposures in particular pools.
       

      1 For the purpose of reporting under SAMA’s loan classification framework, banks should also be able to identify/differentiate defaulted exposures that fall within different categories of classified assets (i.e. Substandard, Doubtful and Loss).
      2 In general, a single corporate borrower grade assigned with more than 30% of the gross exposures (before on-balance sheet netting) could be a sign of excessive concentration.

    • 4.3 Multiple Rating Methodologies/Systems

      4.3.1A bank’s size and complexity of business, as well as the range of products it offers, will affect the type and number of rating systems it has to employ. Where necessary, a bank may adopt multiple rating methodologies/systems within each asset class, provided that all exposures are assigned borrower and facility ratings and that each rating system conforms to the IRB requirements at the outset and on an ongoing basis and is validated for accuracy and consistency.
       
      4.3.2The rationale for assigning a borrower to a particular rating system should also be documented and applied in a manner that best reflects the level of risk of the borrower. Borrowers should not be allocated across rating systems inappropriately to minimize regulatory capital requirements (i.e. cherry-picking by choice of rating system).
       

    • 4.4 Rating Criteria

      4.4.1To ensure the transparency of individual ratings, banks should have clear and specific rating definitions, processes and criteria for assigning exposures to grades within a rating system. The rating definitions and criteria should be both plausible and intuitive, and have the ability to differentiate risk. In particular, the following requirements should be observed:
       
       •The grade descriptions and criteria should be sufficiently detailed and specific to allow staff responsible for rating assignments to consistently assign the same grade to borrowers or 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, banks should monitor for possible inconsistency, and alter rating criteria to improve consistency when appropriate.
       
       •Written rating definitions should be clear and detailed enough to allow independent third parties (e.g. SAMA, internal or external audit) to understand the rating assignments, replicate them and evaluate their appropriateness. The criteria should be consistent with a banks internal lending standards and its policies for handling troubled borrowers and facilities.
       
      4.4.2Banks should take into account all relevant and material information that are available to them when assigning ratings to borrowers and facilities1. Information should be current. The less information a bank has, the more conservative should be its rating assignments. An external rating can be the primary factor determining an internal rating assignment. However, the bank should ensure that other relevant information is also taken into account. Banks should refer to Annex A for the relevant factors in assigning borrower and facility ratings.
       
       SL exposures within the corporate asset class
       
      4.4.3Banks using the supervisory slotting criteria for SL exposures should assign these exposures to internal rating grades based on their own criteria, systems and processes, subject to compliance with the IRB requirements. The internal rating grades of these exposures should then be mapped into five supervisory rating categories. The general assessment factors and characteristics exhibited by exposures falling under each of the supervisory categories are provided Attachment.
       
       Banks should demonstrate that their mapping process has resulted in an alignment of grades consistent with the preponderance of the characteristics in the respective supervisory category. Banks should ensure that any overrides of their internal criteria do not render the mapping process ineffective.
       

      1 It could be difficult to address the qualitative considerations in a structured and consistent manner when assigning ratings to borrowers and facilities. In this regard, banks may choose to cite significant and specific points of comparison by describing how such qualitative considerations can affect the rating. For example, factors for consideration may include whether a borrower‘s financial statements have been audited or are merely compiled from its accounts or whether collateral has been independently valued. Formalizing the process would also be helpful in promoting consistency in determining risk grades. For example, a "risk rating analysis form" can provide a clear structure for identifying and addressing the relevant qualitative and quantitative factors for determining a risk rating, and document how grades are set.

    • 4.5 Rating Assessment Horizon

      4.5.1Although the time horizon used in PD estimation is one year, banks are expected to apply a longer time horizon in assigning ratings. A borrower rating should 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. In other words, the Bank’s assessment should not be confined to risk factors that may occur in the next 12 months.
       
      4.5.2Banks may satisfy this requirement by:
       
       basing rating assignments on specific, appropriate stress scenarios (see subsection 5.5 below); or taking appropriate consideration of 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 should be consistent with current conditions and those likely to occur over a business cycle within the respective industry/geographic region.
       
      4.5.3Given the difficulties in forecasting future events and the influence they will have on a particular borrower’s financial condition, banks should take a conservative view of projected information. Where limited data are available, banks should adopt a conservative bias to their analysis.
       
      4.5.4Banks should articulate clearly their rating approaches (see Annex B for details of rating approaches) in their credit policies, particularly how quickly ratings are expected to migrate in response to economic cycles and the implications of the rating approaches for their capital planning process. If a bank chooses a rating approach under which the impact of economic cycles would affect rating migrations, its capital management policy should be designed to avoid capital shortfalls in times of economic stress.
       

    • 4.6 Use of Models

       Risk assessment techniques
       
      4.6.1There are generally two basic methods by which ratings are assigned: (i) a model-based process; and (ii) an expert judgement-based process. The former is a mechanical process, relying primarily on quantitative techniques such as credit scoring/default probability models or specified objective financial analysis. The latter relies primarily on personal experience and subjective judgment of credit officers1.
       
      4.6.2For IRB purposes, credit scoring models and other mechanical procedures are permissible as the primary or partial basis of rating assignments, and may play a role in the estimation of loss characteristics.
       
       Nevertheless, sufficient human judgment and oversight is necessary to ensure that all relevant and material information is taken into consideration and that the model is used appropriately.
       
       Requirements for using models
       
      4.6.3Banks should meet the following requirements for use of statistical models and other mechanical methods in rating assignments or in the estimation of PD, LGD or EAD:
       
       •Banks should demonstrate that a model or procedure has good predictive power and its use will not result in distortion in regulatory capital requirements. The model should not have material biases. Its input variables should form a reasonable set of predictors and have explanatory capability.
       
       •Banks should have in place a process for vetting data inputs into a statistical default or loss prediction model. This should include an assessment of data accuracy, completeness and appropriateness.
       
       •The data used to build the model should be representative of the population of the bank’s actual borrowers or facilities.
       
       •When model results are combined with human judgment, the judgment should take into account all relevant information not considered by the model. Banks should have written guidance describing how human judgment and model results are to be combined.
       
       •Banks should have procedures for human review of model-based rating assignments. Such procedures should focus on finding and limiting errors associated with model weaknesses. Banks should have a regular cycle of model validation that includes monitoring of model performance and stability, review of model relationships, and testing of model outputs against outcomes (see section 5 of the ”Minimum Requirements for Risk Quantification under IRB Approach”).
       

      1 In practice, the distinction between the two is not precise. In many model-based processes, personal experience and subjective judgment play a role, at least in developing and implementing models, and in constructing their inputs. In some cases, models are used to provide a baseline rating that serves as the starting point in judgment-based processes.

    • 4.7 Documentation of Rating System Design

      4.7.1Banks should document in writing the design of their rating systems and related operations (see section 5 below on rating system operations) as evidence of their compliance with the requirements of this paper.
       
      4.7.2The documentation should provide a description of the overarching design of the rating system, including:
       
       the purpose of the rating system;
       
       portfolio differentiation; and
       
       the rating approach and implications for a bank capital planning process.
       
      4.7.3Rating criteria and definitions should be clearly documented. These include:
       
       •The relationship between borrower grades in terms of the level of risk each grade implies, and the risk of each grade in terms of both a description of the probability of default typical for borrowers assigned the grade and the criteria used to distinguish that level of credit risk;
       
       •The relationship between facility grades in terms of the level of risk each grade implies, and the risk of each grade in terms of both a description of the expected severity of the loss upon default and the criteria used to distinguish that level of credit risk;
       
       •Methodologies and data used in assigning ratings;
       
       •The rationale for choice of the rating criteria and procedures, including analyses demonstrating that those criteria and procedures should be able to provide meaningful risk differentiation;
       
       •Definitions of default and loss, demonstrating that they are consistent with the reference definitions set out in subsections 4.2 and 4.3 of the “Minimum Requirements for Risk Quantification under IRB Approach”; and
       
       •The definition of what constitutes a rating exception (including an override).
       
      4.7.4Documentation of the rating process should include the following key topics as a minimum. The Format and size is at the discretions of the banks.
       
       •The organization of rating assignment;
       
       •Responsibilities of parties that rate borrowers and facilities;
       
       •Parties that have authority to approve exceptions (including overrides);
       
       •Situations where exceptions and overrides can be approved and the procedures for such approval;
       
       •The procedures and frequency of rating reviews to determine whether they remain fully applicable to the current portfolio and to external conditions, and parties responsible for conducting such reviews;
       
       •The process and procedures for updating borrower and facility information;
       
       •The history of major changes in the rating process and criteria, in particular to support identification of changes made to the rating process subsequent to the last supervisory view1; and
       
       •The rationale for assigning borrowers to a particular rating system if multiple rating systems are used.
       
      4.7.5In respect of the internal control structure, the documentation should cover the following:
       
       •The organization of the internal control structure;
       
       •Management oversight of the rating process;
       
       •The operational processes ensuring the independence of the rating assignment process; and the procedure, frequency and reporting of performance reviews of The rating system (on rating accuracy, rating criteria, rating processes and operations), and parties responsible for conducting such reviews.
       
      4.7.6Banks employing statistical models in the rating process should document their methodologies. The documentation should include:
       
       •A detailed outline of the theory, assumptions and/or mathematical and empirical basis of the assignment of estimates to grades, individual borrowers, exposures, or pools, and the data sources used to estimate the model;
       
       •The guidance describing how human judgment and model results are to be combined;
       
       •The procedures for human review of model-based rating assessments;
       
       •A rigorous statistical process for validating the model; and
       
       •Any circumstances under which the model does not work effectively.
       
      4.7.7Use of a model obtained from a third-party vendor that claims proprietary technology is not a justification for exemption from documentation or any other requirements for internal rating systems. The burden is on the model’s vendor and the bank to satisfy SAMA.
       

      1 The supervisory review could be a review conducted by either the SAMA or the home supervisor of the bank concerned (in the case of a foreign bank branch).