Annex B : Rating Approaches
B1 Background
B1.1 In 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
B2.1 In 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.
B2.2 A 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
B3.1 A 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.
B3.2 Similar 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.