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  • 8 Disclosure Requirements

    8.1In order to be eligible for the IRB Approach, banks should meet the requirements set out in the disclosure rules under Pillar III. Failure to meet the disclosure requirements will render a bank ineligible to use the relevant IRB Approach.
     

    • Table 1: Summary of Key Aspects of an Internal Rating System

      (A) Requirements (B) Rating Process (C) Use of Ratings
      Rating structure: Rating assignment: Credit risk measurement and management:
      • Maintain a two-dimensional system.
      • Appropriate gradation.
      • No excessive concentration in a single grade
      		 
      • Ratings assigned before lending/investing.
      • Independent review of ratings assigned at origination.
      • Comprehensive coverage of ratings.
      		 
      • Credit approval
      • Loan pricing
      • Reporting of risk profile of portfolio to senior management and board of directors.
      • Analysis of capital adequacy, reserving and profitability of Banks
           
      Key data requirements: Rating review: Stress test used in assessment of capital adequacy:
      • Probability of default (PD)
      • Loss given default (LGD)
      • Exposure at default (EAD)
      • History of borrower defaults
      • Rating decisions
      • Rating histories
      • Rating migration.
      • Information used to assign the ratings
      • Party/model that assigned the ratings
      • PD/LGD estimate histories
      • Key borrower characteristics and facility information.
      		 
      • Independent review (annual or more frequent depending on loan quality and availability of new information) by control functions such as credit risk control unit, internal and external audit.
      • Oversight by senior management and board of directors.
      		 
      • Stress-testing should include specific scenarios that assess the impact of rating migrations.
      • Three areas that banks could usefully examine are economic or industry downturns, market risk events and liquidity conditions.
           
      System requirements: Internal Validation: Disclosure of key internal rating information:
      • The IT system should be able to store and retrieve data for exposure aggregation, data collection, use and management reporting.
      		 
      • A robust system for validating the accuracy and consistency of rating systems, processes, and risk estimates.
      • A process for vetting data inputs.
      • Compare realized default rates with estimated PDs.
      		 
      • Disclosure of items of information as started under (the disclosure rules).

    • Annex A : Assessment Factors in Assigning Ratings

      • A1 Borrower Ratings

        A1.1The following are the relevant factors that banks should consider in assigning borrower ratings. However, these factors are not intended to be exhaustive or prescriptive, and certain factors may be of greater relevance for certain borrowers than for others:
         
         •the historical and projected capacity to generate cash to repay a borrower’s debt and support its other cash requirements (e.g. capital expenditures required to keep the borrower a going concern and to sustain its cash flow);
         
         •The capital structure and the likelihood that unforeseen circumstances could exhaust the borrower’s capital cushion and result in insolvency;
         
         •The quality of earnings (i.e. the degree to which the borrower’s revenue and cash flow emanate from core business operations as opposed to unique and nonrecurring sources);
         
         •The quality and timeliness of information about the borrower, including the availability of audited financial statements and their conformity with applicable accounting standards;
         
         •The degree of operating leverage and the resulting impact that deteriorating business and economic conditions might have on the borrower’s profitability and cash flow;
         
         •The borrower’s ability to gain additional funding through access to debt and equity markets;
         
         •The depth and skill of management to effectively respond to changing conditions and deploy resources, and the degree of prudence reflected from business strategies employed;
         
         •The borrower’s position within the industry and its future prospects; and
         
         •The risk characteristics of the country the borrower is operating in, and the extent to which the borrower will be subject to transfer risk or currency risk if it is located in another country.
         

        • A2 Facility Ratings

          A2.1Banks should look at the following transaction specific factors, where applicable, when assigning facility ratings:
           
           •The presence of third-party support (e.g. owner/guarantor). Considerable care and caution should be exercised if ratings are to be improved because of the presence of any third-party support. In all cases, banks should be convinced that the third party is committed to ongoing support of the borrower. Banks should establish specific rules for third-party support;
           
           •The maturity of the transaction. It is recognized that higher risk is associated with longer-term facilities while shorter-term facilities tend to have lower risk. A standard approach is to consider further adjustment to the facility rating (after adjusting for third-party support), taking into account the remaining term to maturity;
           
           •The structure and lending purposes of the transaction, which influence positively or negatively the strength and quality of the credit. These may refer to the status of borrower, priority of security, any covenants attached to a facility, etc. Take, for example, a facility that has a lower rating due to the term of a loan. If its facility structure contains very strong covenants which mitigate the effects of its term of maturity (say, by means of default clauses), it may be appropriate to adjust its facility rating to offset (often partially) the effect of the maturity term.
           
           •The presence of recognized collateral. This factor can have a major impact on the final facility rating because of its significant effect on the LGD of a facility. Banks should review carefully the quality of collateral (e.g. documentation and valuation) to determine its likely contribution in reducing any loss. While collateral value is often a function of movements in market rates, it should be assessed in a conservative manner (e.g. based on net realizable value or forced-sale value where necessary).
           

        • Annex B : Rating Approaches

          • B1 Background

            B1.1In choosing the architecture of its rating system, a bank should decide whether borrowers are graded according to their expected default rates over the following year (i.e. a point-in-time rating system) or their expected default rates over a wider range of possible stress outcomes (i.e. a through-the-cycle rating system). Choosing between a point-in-time rating system and a through-the-cycle rating system has implications on the banks capital planning process because of the different impact an economic cycle may have on the rating transitions arising from the two different systems.
             

            • B2 Point-in-Time Rating System

              B2.1In a point-in-time rating system, an internal rating reflects an assessment of the borrower’s current condition (such as its financial strength) and/or most likely future condition over the forecast horizon (say one year). As such, the internal rating changes as the borrower’s condition changes over the course of the economic/business cycle. As the economic circumstances of many borrowers reflect the common impact of the general economic environment, the transitions in point-in-time ratings will reflect fluctuations in the economic cycle.
               
              B2.2A Bank adopting a point-in-time rating system is likely to experience greater changes in its capital requirements in response to fluctuations in an economic cycle than others adopting a through-the-cycle rating system (see subsection B3 below). Therefore, the bank’s capital management policy should be designed to avoid capital shortfall in times of systemic economic stress.
               

              • B3 Through-the-Cycle Rating System

                B3.1A through-the-cycle process requires assessment of the borrower’s risk ness based on a worst-case scenario, i.e. the bottom of an economic/business cycle. In this case, a borrower rating would tend to stay the same over the course of an economic cycle unless the borrower experiences a major unexpected shock to its perceived long-term condition or the original “worst” case scenario used to rate the borrower proves to have been too optimistic.
                 
                B3.2Similar to point-in-time ratings, through-the-cycle ratings also change from year to year to reflect changes in borrowers’ circumstances. However, year-to-year transitions in through-the-cycle ratings will be less influenced by changes in the actual economic environment as this approach abstracts from the immediate economic circumstances and considers the implications of hypothetical stressed circumstances.