66. Institutions should choose an appropriate philosophy underlying the assignment of obligors or …

Institutions should choose an appropriate philosophy underlying the assignment of obligors or exposures to grades or pools (‘rating philosophy’) taking into account all of the following principles:

• (a) Institutions should assess whether the method used to quantify the risk parameter is adequate for the rating philosophy and understand the characteristics and dynamics of the assignment of obligors or exposures to grades or pools (‘rating assignment’) and of the risk parameter estimates that result from the method used.
• (b) Institutions should assess the adequacy of the resulting characteristics and dynamics of the rating assignment and risk parameter estimates that result from the method used, with regard to their various uses and should understand their impact on the dynamics and volatility of own funds requirements.
• (c) The rating philosophy should also be taken into account for back testing purposes. Philosophies sensitive to economic conditions tend to estimate PDs that are better predictors of each year’s default rates. On the other hand, philosophies less sensitive to economic conditions tend to estimate PDs that are closer to the average PD across the various states of the economy, but that differ from observed default rates in years where the state of the economy is above or below its average. Deviations between observed default rates and the long-run average default rate of the relevant grade will hence be more likely in rating systems less sensitive to economic conditions. In contrast, migrations among grades will be more likely in rating systems which are more sensitive to economic conditions. These patterns should be taken into account when assessing the results of back-testing and, where relevant, benchmarking analysis.

1. Overview

1.1 References

1.2 Identified Requirements

1.3 Related Standards

2. Identified Requirements

3. Related Standards

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