Table 1: Rating and calibration philosophies

(*) LRA DR – long-run average default rate

For the purpose of aligning terminology, the GL define calibration in relation to PD estimation as the process of ensuring that the PDs assigned to grades or pools reflect the long-run average default rate at the level relevant to the applied calibration method.

For the avoidance of doubt, it is clarified that where banks apply scoring models and specify score intervals representative of a common level of risk, and where obligors or exposures whose scores fall into such an interval receive the same PD estimate, this process may be considered part of the calibration.

Moreover, the GL provide an overview of the calibration methods mentioned in the CRR, and state to which type of exposures, for instance retail, non-retail or purchased receivables, they are applicable. In addition, the GL clarify that each calibration method may consider the long-run average default rate at the level of the calibration segment, or at grade or pool level. Where there is only one calibration segment in a portfolio, calibration at the level of the calibration segment corresponds to calibration at portfolio level. To incentivise understanding and awareness of these different levels of calibration, and to limit RWA variability stemming from these choices, the GL require that institutions perform additional calibration tests at the level of the calibration segment where calibration is performed at the grade or pool level, and vice versa. For portfolio calibration, where the grades or pools are not available, this additional calibration test would require grouping of ranked exposures into artificial grades to allow performing the calibration test at the level of these grades. For this purpose, the grouping may be the same as for back-testing.

Regardless of the chosen level of calibration the objective is to obtain PDs at grade level that are representative of the long-run average default rate. In this sense, the portfolio level calibration is a method to obtain this long-run average default rate at a grade level, for instance where institutions do not have information at grade level for the whole historical observation period. It could therefore be seen as a two-step calibration, i.e. the first step would be to obtain the portfolio default rate

level. With direct estimates in accordance with Article 169(3) of the CRR, the risk estimates assigned to individual obligors or exposures may be seen as estimates assigned to grades on a continuous rating scale. Where calibration includes steps performed on a portfolio level, and on a grade or pool level, the additional calibration tests should be applied to the last calibration step.

Furthermore, these GL contain a definition of the calibration sample, which is defined as the data set on which the PD estimates are evaluated to perform the calibration. This notion is introduced because the GL refer to this data set and require that institutions find an appropriate balance between the calibration sample being comparable to the current portfolio, in terms of obligor and transaction characteristics, and it reflecting the likely range of variability of default rates.

performed before the application of MoC and floors on PD, as required by Articles 160(1) and 163(1) of the CRR (PD floors), and after taking overrides into account. The rationale for this is that the application of MoC or PD floors in the calibration could lead to significant underestimation of final PD estimates of a grade or pool. For example, where an institution estimates PDs as simple averages of default probability estimates in a given grade in accordance with Article 180(1)(g) of the CRR, a group of obligors with significantly different levels of default risk could be grouped into one grade or pool if MoC or PD floors were applied before calibration. It should be noted that this provision clarifies that, even where a bank has a current portfolio fully representative of the historic portfolio and of the likely range of default rates, and where the calibration sample therefore corresponds to the current portfolio, it is still expected that the final PD estimate is higher than the average of default risk probabilities due to MoC and PD floors. Moreover, overrides should be taken into account to the extent relevant and observed for the ranking method underlying the grades and pools for which the calibration is performed.

The GL acknowledge that, regarding the policy on rating philosophy and calibration outlined above, there is a wide range of practices. However, the distinction between model development (leading to risk differentiation) and calibration, including estimation of long-run average default rates (leading to risk quantification), should not prohibit institutions from using methods where some aspects of both stages are combined.

⁷ For example, where the re-calibration incorporates some amendment to a qualitative module of the rating model, it might not be possible to assess the correct grade retrospectively for all obligors, as experts would have to historically review every rating of every obligor subject to this module within the historical observation period.

⁸ Methods should be carefully assessed to ensure that they do not contain survivor bias.

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