Overview

To qualify for the internal ratings-based approach, highlighted in this chapter, regulators must be convinced that a financial institution meets preset minimum requirements (see Chapter 2). The purpose of these requirements is to make sure that banks rating systems are precise, that they demonstrate integrity, and importantly, that default frequency, loss given default, and loss reserves estimates are comparable over time and across banks.

Internal risk ratings are an important tool in monitoring credit risk. Internal risk ratings should be adequate to support the identification and measurement of risk from all credit exposures, and should be integrated into an institution s overall analysis of credit risk and capital adequacy. The ratings system should provide detailed ratings for all assets, not only for criticized or problem assets. Loan loss reserves should be included in the credit risk assessment for capital adequacy. ^[1.]

Credit risk rating allows a customized and elastic approach to loan pricing, loan loss reserves, and estimating default probabilities and loss given default. Robust computerdriven, interactive models track and rate changes in product and operational strategies, credit quality, market variables, economic environment, and operational risk (loan documentation and auditing issues). The degree by which risk models have been incorporated into credit management and economic capital allocation processes varies among banks. The use of credit risk models offers banks a framework for examining this risk in a timely manner, centralizing data on global exposures (see Chapter 13), and analyzing marginal and absolute contributions to risk. These properties contribute to the...