Features of internal rating

Under Basel II bank internal credit ratings may be used for calculating the minimum capital a
bank has to allocate against each individual loan. As these minimum capital requirements will be
reflected in the margin and credit terms the importance of bank internal ratings is going to
increase in the future.

Managing credit risk

Banks implement internal credit ratings to evaluate the likelihood of a corporate customer defaulting
on its obligations.

The objective of bank ratings is to differentiate the risks inherent in a loan portfolio. Rating systems
measure credit risk and distinguish individual debtors, credits and groups of credits by the risk they
pose. In addition, they should indicate the individual drivers of default risk, highlight changes and
enable banks to monitor trends in risk levels.

The banks internal use of ratings

Once a bank has classified its customers with ratings, the ratings can become an integral part of the
internal management. For example, bank internal ratings can be used as the basis for:

credit approval.
loan limit systems.
risk management measures.
loan pricing.
Overall the internal rating process enables banks to manage risk and optimise returns.

Banking industry oversight

Internal credit rating systems support the stability of the banking system when they enhance the
banks informed decision making and contribute to their risk management.

This has been recognized by the new Basel Capital Accord (Basel II) which identifies the importance of
internal bank rating systems for the stability of the banking industry.

Minimum capital allocation

Under Basel II, banks will be able to use their internal credit rating systems to calculate
minimum capital requirements
The banks that decide to adopt this Internal Ratings-Based (IRB) approach use their own internal
credit ratings and loss data to provide estimates of:

The borrowers Probability of Default (PD).

PD is the risk that a borrower will be unable or unwilling to repay debt in full or on time.
The facilitys Loss Given Default (LGD).
LGD is the financial loss that a bank incurs when the borrower cannot or will not repay debt.
The Level of Exposure at the time of Default (EAD).
Maturity.
Default probability due to systemic risk is independent of maturity, but long maturity loans are
more susceptible to the volatility of ratings and credit spreads. As this can affect the value a loan
has to a bank, the inclusion of maturity data incorporates this effect in the rating.
Foundation IRB

Foundation Approach:
1) The bank undertakes analysis of historical data for different types of
loan facilities such as corporates , retail , housing loans etc., from which
probabilities of default are calculated.
2) The ratings of accounts is done by the banks internally.
In case of some large accounts both internal and external rating is
undertaken.
3)The risk weights are calculated by the bank based on probabilities of
default.
4) The estimate of LGD is given by the RBI.
5) In case of collaterals recognized by RBI risk weights are reduced as per
RBI instructions.

Advanced-IRB

Advanced Internal Risk based approach:

1) All assets are classified into different categories such as corporate,
retail, housing etc. The risk weights are estimated by the bank on the basis
of historical data.
2) All parameters such as PD,LGD and EAD is estimated by the bank.
3) Estimates of EL and UL are calculated.
4) All the estimates have to be informed RBI(Regulator)
5) The banks are required to take permission of the regulator before
adopting A-IRB approach.
An exposure to a corporation, partnership or proprietorship falls under this category. Some special
guidelines may apply if the corporation is small or medium-sized entity (SME). As noted above, there
are five sub-classes of specialized lending under this asset class -

Project Finance - financing industrial projects based upon the projected cash flows of the
particular project
Object Finance - financing physical assets based upon the projected cash flows obtained
primarily through the rental or lease of the particular assets
Commodities Finance - financing the reserves, receivables or inventories of exchange-traded
commodities where the exposure is paid back based on the sale of the commodity rather than
by the borrower from independent funds
Income-producing real estate - financing real estate that is usually rented or leased out by the
debtor to generate cash flow to repay the exposure
High-volatility commercial real estate - financing commercial real estate, which demonstrate a
much higher volatility of loss rates as compared to other forms of specialized lending
Sovereign[edit]
This generally refers to a loan made to a particular country. Under the Basel II guidelines, this class
also includes the central banks of various countries, certain public sector enterprises (PSEs) and
the multilateral development banks (MDBs) that meet the criteria for a 0% risk weight under
the standardized approach.

Bank[edit]
Loans made to banks or securities firms subject to regulatory capital requirements come under this
category. Certain domestic PSEs or MDBs that do not meet the criteria for a 0% risk weight under
the standardized approach also fall in this category.

Retail[edit]
Loans made to individuals fall under this category. Credit cards, overdrafts or residential
mortgages are some of the common retail lending products treated as part of this category in the
IRB approach. Subject to a maximum of 1 million euros, exposures to small businesses managed as
retail exposures also fall under this category.
Retail exposures are usually not managed by the bank on an individual basis for risk rating
purposes, but as groups of exposures with similar risk characteristics. The sub-classes of exposures
falling into this category are -

Residential mortgage
Qualifying revolving exposure (QREs) [4] - unsecured revolving exposures where the undrawn
portion of the exposure is unconditionally cancellable by the bank
Other retail
Equity[edit]
Direct ownership interests in the assets and income of a financial institution, or indirect interests
through for example derivatives come under this category. For an exposure to qualify under this
category, the return of the funds invested on the equities can be only realized through their sale or
by liquidation of the issuer of these equities.
The banks internal use of ratings
Once a bank has classified its customers with ratings, the ratings can become an integral part of the
internal management. For example, bank internal ratings can be used as the basis for:

credit approval.
loan limit systems.
risk management measures.
loan pricing.
Overall the internal rating process enables banks to manage risk and optimise returns.

There are three parameters for quantifying risk.

These are called risk components.
1) Probability of Default (PD)
2) Exposure At Default (EAD)
3) Loss Given Default (LGD)

Probability of Default:

It is a likelihood that the counterparty will default on its obligation during

one year.
It is a number between zero and 1.
If PD is zero means borrower will not surely default and
if PD is 1 means borrower will surely default.

Exposure at Default:

It is the outstanding amount at time of default.

Default can occur at any time during the currency of the loan.
Suppose Term loan of Rs15,00,000 is granted in Dec 2011. After 5 years
amount outstanding is 7,00,000 as borrower has paid entire interest and the
principal amount but defaulted now. Thus EAD is 7 lacs.
EAD can be more or less than sanctioned credit limit.

Loss Given Default (LGD)

The entire amount outstanding at the time of default is not the amount lost
by the bank .
 Some amount is recoverable through
sale of securities mortgaged or
through court or from
Credit Guarantee Corporation.
The loss is the amount bank is forced to write off when all means of
recovery have been exhausted.
This amount is called as Loss incurred when default has occurred.
This is called Loss Given Default.