5. Rating System Operations
5.1 Coverage of Ratings
5.1.1 For corporate, sovereign and bank exposures, each borrower and all recognized guarantors should be assigned a rating and each exposure should be associated with a facility rating as part of the loan approval process. Similarly, for retail exposures, each exposure should be assigned to a pool as part of the loan approval process.
5.1.2 Each separate legal entity to which a bank is exposed should be separately rated. A bank should demonstrate to SAMA that it has acceptable policies 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.
5.2 Integrity of Rating Process
Corporate, sovereign and bank exposures
5.2.1 Banks should ensure the independence of the rating assignment process. Rating assignments and periodic rating reviews should be completed or approved by a party that does not stand to benefit from the extension of credit. Credit policies and approval/review procedures should reinforce and foster the independence of the rating process.
5.2.2 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.
(Refer para 425, International Convergence of Capital Measurement and Capital Standards – June 2006)
5.2.3 In addition, borrower and facility ratings should be reviewed whenever material information on the borrower or facility comes to light1. Bank should establish an effective process to obtain and update relevant and material information on the borrower’s financial condition, and on facility characteristics that affect LGD and EAD (e.g. the condition and value of collateral).
Retail exposures
5.2.4 Banks should review the loss characteristics and delinquency status of each identified risk pool at least on an annual basis. It should include a review of 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.
1 The rating should generally be updated within 90 days for performing borrowers and within 30 days for borrowers with weakening or deteriorating financial condition.
5.3 Overrides
5.3.1 Banks should clearly articulate the situations where human judgment may override the inputs or outputs of the rating process. They should identify overrides and separately track their performance.
5.3.2 For model-based ratings, banks should have guidelines and processes for monitoring cases where human judgment has overridden the model’s rating, variables were excluded or inputs altered. These guidelines should include identifying personnel that are responsible for approving the overrides.
5.3.3 For ratings based on expert judgment, banks should clearly articulate the situations where staff may override the outputs of the rating process, including how and to what extent such overrides can be used and by whom.
5.4 Data Maintenance
5.4.1 Banks should collect and store data on key borrowers and facility characteristics to support their internal credit risk measurement and management process and to enable them to meet the requirements of this paper. The data collection and IT systems should serve the following purposes:
• Improve banks’ internally developed data for
• PD/LGD/EAD estimation and validation;
• Provide an audit trail to check compliance with rating criteria;
• Enhance and track predictive power of the rating system;
• Modify risk rating definitions to more accurately address the observed drivers of credit risk; and
• Serve as a basis for supervisory reporting.
5.4.2 The data should be sufficiently detailed to allow retrospective reallocation of borrowers and facilities to grades (e.g. if it becomes necessary to have finer segregation of portfolios in future).
5.4.3 Furthermore, banks should collect and retain data relating to their internal ratings as required under [the disclosure rules].
Corporate, sovereign and bank exposures
5.4.4 Bank should maintain complete rating histories on borrowers and recognized guarantors, which include:
• The ratings since the borrower/guarantor was assigned a grade;
• The dates the ratings were assigned;
• The methodology and key data used to derive the ratings;
• The person/model responsible for the rating assignment;
• The identity of borrowers and facilities that have defaulted, and the date and circumstances of such defaults; and
• data on the PDs and realized default rates associated with rating grades and rating migration.
5.4.5 Banks adopting the Advanced IRB Approach should also collect and store a complete history of data on facility ratings and LGD and EAD estimates associated with each facility. These include:
• The dates the ratings were assigned and the Estimates done;
• The key data and methodology used to derive the facility ratings and estimates;
• The person/model responsible for the rating
• assignment and estimates;
• Data on the estimated and realized LGDs and
• EADs associated with each defaulted facility;
• Data on the LGD of the facility before and after evaluation of the credit risk mitigating effects of the guarantee/credit derivative; and
• Information on the components of loss or recovery for each defaulted exposure, such as amounts recovered, source of recovery (e.g. collateral, liquidation proceeds and guarantees), time period required for recovery, and administrative costs.
5.4.6 Banks utilizing supervisory estimates under the Foundation IRB Approach are encouraged to retain:
• Data on loss and recovery experience for corporate exposures under the Foundation Approach; and
• Data on realized losses for SL exposures where supervisory slotting criteria are applied.
Retail exposures
5.4.7 Banks should collect and store the following data:
• 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;
• Data on the estimated PDs, LGDs and EADs associated with pools of exposures;
• The identity of borrowers and details of exposures that have defaulted; and
• Data on the pools to which defaulted exposures were assigned over the year prior to default and the realized outcomes on LGD and EAD.
5.5 Stress Tests Under IRB Approaches
5.5.1 Banks adopting the IRB Approaches should implement sound stress-testing processes for use in their assessment of capital adequacy. Stress testing should identify possible events or changes in economic conditions that could have unfavorable effects on a banks’ credit exposures, and assess the bank’s ability to withstand such changes. Stress tests conducted by a bank should cover a wide range of external conditions and scenarios, and the sophistication of techniques and stress tests used should be commensurate with the bank’s activities.
5.5.2 Described below are some common risk factors that are relevant to and need to be considered in credit risk stress tests:
• Counterparty risk characterized by the increase in PDs (e.g. the rise in delinquencies and charge offs) and worsening of credit spreads. Banks should be aware of the major drivers of repayment ability, such as economic/industry downturns and significant market shocks, that will affect entire classes of counterparties or credits;
• Concentration risk in terms of the exposures to individual counterparties, industries, market sectors, countries or regions. Banks should assess the contagion effects and possible linkages between different markets, countries and regions as well as the potential vulnerabilities of emerging markets;
• Market or price risk arising from adverse changes in asset prices (e.g. equities, bonds and real estate) and their impact on relevant portfolios, markets and collateral values; and
• Liquidity risk as a result of the tightening of credit lines and market liquidity under stressed situations.
5.5.3 Banks should determine the appropriate assumptions for stress-testing risk factors included in a particular stress scenario, and formulate the stressed conditions based on their own circumstances. In designing stress scenarios, banks should review lessons from history and tailor the events, or develop hypothetical scenarios, to reflect the risks arising from latest market developments.
5.5.4 SAMA will consider the results of stress tests conducted by a bank and how these results relate to its capital plans.
5.5.5 In addition to the general stress tests described above, banks should conduct a regular credit risk stress tests to assess the effect of certain specific conditions on their total regulatory capital requirements for credit risk. The tests should be meaningful and reasonably conservative. For this purpose, banks should at least consider the effect of mild recession scenarios on their PDs, LGDs and EADs. Where a bank operates in several markets, it need not conduct such a stress test in all of those markets, but it should stress portfolios containing the majority of its total exposures.
5.5.6 At a minimum, a mildly stressed scenario chosen by a bank should resemble the economic recession in Saudi Arabia in the past. Banks should assess the impact of this stress scenario based on a one-year time horizon and take into account the lag effect of an economic downturn on their credit exposures.
5.5.7 Banks may use either a static or a dynamic test to calculate the impact of the stress scenario1.
5.5.8 Where the results of a bank’s stress test indicate a deficiency of the capital calculated based on the IRB Approach (i.e. the capital charge cannot cover the losses based on the stress-testing results), SAMA will discuss this deficiency with the bank’s management. Depending on the circumstances of each case, SAMA will require the bank to reduce its risks and/or to hold additional capital/provisions, so that existing capital resources could cover the minimum capital requirements under the IRB Approach plus the result of a recalculated stress test.
5.5.9 Through the review of stress-testing results, regulatory capital could be calculated based on a more forward-looking basis, thereby reducing the impact of rising capital requirements during an economic down turn.
1 A static test considers the impact of a stress scenario on a fixed portfolio. A dynamic test typically involves modeling the evolution of a stress scenario through time (possibly including elements such as changes in the composition of a portfolio).