4.5 Internal Ratings

Internal ratings represent banks internal and usually undisclosed judgments about the riskiness of a given borrower or exposure. In most cases internal rating scales are bidimensional; i.e., they address separately the PD of the borrower and the LGD of the given facility (which may depend on covenants, third-party guarantees, and similar factors that are independent of the borrower s PD). Internal ratings are typically defined with numerical grades, and the number and granularity of credit grades varies from one bank to another. Larger and/or more sophisticated institutions typically use a higher number of different grades, in order to differentiate better among customers for credit risk measurement, pricing, and capital allocation purposes. A hypothetical example assuming 10 internal classes given in Table 4-6.

Before discussing internal rating systems in detail, it may be useful to summarize some of the key qualitative prescriptions from the Basel II Accord for those banks applying for IRB approaches (Table 4-7). While some of them may derive from specific supervisors needs, most represent best-practice...