5.2 Model development in PD estimation

For the purpose of model development, institutions should ensure that the RDS contains the values of the risk drivers for appropriate points in time. These points in time may vary between different risk drivers. In the selection of appropriate points in time institutions should take into account the dynamics as well as the update frequency of the risk drivers throughout the whole period in which an obligor was in the portfolio and, in the case of a default, throughout the year prior to default.

5.2.2 Risk drivers and rating criteria

In the process of selecting risk drivers and rating criteria, institutions should consider a broad set of information relevant to the type of exposures covered by the rating system. Potential risk drivers analysed by institutions should include in particular the following:

• (a) obligor characteristics, including sector and geographic location for corporates;
• (b) financial information, including financial statements or income statements;
• (c) trend information, including growing or shrinking sales or profit margin;
• (d) behavioural information, including delinquency and the use of credit facilities.

Institutions should ensure that for the purpose of selecting risk drivers and rating criteria the relevant experts from business areas of the institution are consulted with respect to the business rationale and risk contribution of the considered risk drivers and rating criteria.

Institutions should ensure that the decrease of reliability of information over time, for instance of information on obligor characteristics obtained at the time of the loan origination, is appropriately reflected in the PD estimation. Institutions should also ensure that the model estimates the proper level of risk with respect to all relevant, currently available and most up-to-date information and that an adequate MoC is applied where a higher degree of uncertainty exists due to the lack of up-to-date information. In particular the model or the assignment process should provide for an adequate and conservative adjustment in both of the following situations:

• (a) in accordance with Article 24(1)(g) of the RTS on IRB assessment methodology, in case of financial statements older than 24 months where information stemming from these financial statements is a relevant risk driver;
• (b) in the case of credit bureau information that is older than 24 months, if still relevant at that point in time, where credit bureau information is a relevant risk driver.

Institutions should use the risk drivers and rating criteria consistently, in particular with respect to the considered time horizon, in model development, model calibration and model application.

Where there is a significant proportion of customers using multiple facilities of the same type within a considered retail rating system institutions should analyse the level of risk of such customers compared with customers carrying only one facility of the relevant type and, where necessary, reflect the difference in the level of risk in the model through appropriate risk drivers.

5.2.3 Treatment of ratings of third parties

Institutions should have clear policies specifying the conditions under which the rating of a third party who has a contractual or organisational relation with an obligor of the institution may be taken into account in the assessment of risk of the considered obligor. Such policies should take into account the following possible manners in which the rating of such a third party may be taken into account in the assessment of risk of the considered obligor:

• (a) the rating of such third party being transferred to a relevant obligor (‘rating transfer’), where there is no difference in risk between the obligor and the related party because of the existence of an appropriate guarantee and the rating of a third party is assigned internally in accordance with the rating system for which the institution has received permission in accordance with Article 143(2) of Regulation (EU) No 575/2013;
• (b) the rating of a such third party being taken into account as an indication for an override of the assignment of the relevant obligor to a grade or pool;
• (c) the rating of such a third party serving as an input to the PD model, reflecting contractual support of the related party for the obligor.

In order for an internal or external ratings of a third party to be incorporated into a PD model, institutions should ensure all of the following:

• (a) that the rating of a third party fulfils all the requirements for relevant risk drivers set out in section 5.2.2;
• (b) that other relevant obligor and transaction risk characteristics are properly reflected in the model in accordance with Articles 170(1)(a) and 170(3)(a) of Regulation (EU) No 575/2013, and that no material biases are introduced by a high weighting of the internal or external rating information;
• (c) that there is no double counting of effects of any relations to third parties.

A rating transfer should not change the assignment of exposures to exposure classes, rating systems or models, but should only affect the assignment to grades or pools. Rating transfers should be set up in such a way that any changes to a rating of a third party which is material information on the obligor or exposure with regard to Article 173(1)(b) of Regulation (EU) No 575/2013 is reflected in all influenced ratings in a timely manner.

The material contractual support granted by an obligor to a third party should be seen as diminishing the free financial strength of the supporting obligor, including the strength to repay all obligations to the institution in full. This should be reflected in the rating of the supporting obligor.

5.2.4 Rating philosophy

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.

Institutions should apply the chosen rating philosophy consistently over time. Institutions should analyse the appropriateness of the philosophy underlying the assignment of obligors or exposures to grades or pools (‘rating philosophy’), taking into account all of the following:

• (a) design of risk drivers;
• (b) migration across grades or pools;
• (c) changes in the yearly default rates of each grade or pool.

Where institutions use different rating systems characterised by different rating philosophies, they should use the information on the rating assignments or risk parameters estimates with caution, especially when making use of rating information or default experience obtained from external rating agencies. Where institutions use different rating systems with different characteristics, such as different philosophies or different levels of objectivity, accuracy, stability, or conservatism, they should ensure that the rating systems have an appropriate level of consistency and that any differences between them are well understood. Such understanding should at least enable the institution to define an appropriate way to combine or aggregate the information produced by the various rating systems when this is necessary according to the institution’s policies. Institutions should have full understanding of the assumptions and potential inaccuracies arising from such a combination or aggregation.

5.2.5 Homogeneity of obligor grades or pools

In order to comply with the requirements of Article 170(1) and 170(3)(c) of Regulation (EU) No 575/2013 and of Article 38 of the RTS on IRB assessment methodology, institutions should check the homogeneity of obligors or exposures assigned to the same grades or pools. In particular, grades should be defined in such a manner that each obligor within each grade or pool has a reasonably similar risk of default and that significant overlaps of the distributions of the default risk between grades or pools are avoided.