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External and Internal Ratings

4 important questions on External and Internal Ratings

What about internal ratings?

Banks attempt to mirror the rating behavior of external rating agencies for a better view on creditworthiness of clients and incorporate it in capital calculations. Used to be black-white criteria but that means that no differentiation among GOOD customers can be made.

Objectivity in rating allocation, forecast information, time horizon and consistency is questionable.

Note: sudden defaults without preliminary downgrades are rare (1/10)

Two ways to rate/score?

At the point (PIT) and through the cycle (TTC), huge horizon difference. Problem is also that corporate approach is more qualitative and smal exposures more quantitative (score approach). Mixture of PIT and TTC. PRoblem is that PIT is much more volatile. But note that this is much worse for median rating than for high and low ratings.

Problem with score (logit) approach is that the diagonal is much less stable as in a usual transition matrix. Huge challenge to find the tradeoff between stability in ratings and predictive power!!! TTC can be derived from PITs.

How to build internal rating system?

Especially needed for less obvious asset classes.
1) Determine/identify most meaningful criteria and risk factors
2) Assign weights to these criteria (qualitative or quantitative), crucial point!!
3) Calibrate internal rating process
4) Test the stability of internal transition matrices (backtesting)

Two-fold objective:
- Assess creditworthiness
- Feed portfolio management tools (capital)

For low ratings less years of data is needed to build a good model, generally 10 years is advisable. Ex post statistical testing is the next step.

Tradeoff is often stability in transition matrix or in PDs per rating

Impact of internal models?

Procyclicality is a big problem. Linking capital requirements to PDs may induce banks to overlend in good times and underlend in bad times, thereby reinforcing credit and economic cycles. Expected loss will be very volatile., can cause liquidity shortage as no bank is willing to lend. As defaults take time to take place, defaults lack an economic cycle. Problem is that banks lack incentives to quickly anticipate their lending specs due to this.