Credit Risk Rating at Australian Banks

Credit Risk Rating at Australian Banks Working Paper 7 December 2000 Andrew McDonald Guy Eastwood CREDIT RISK RATING AT AUSTRALIAN BANKS Andrew McDonald and Guy Eastwood Working Paper 7 ABSTRACT This working paper summarises a survey of the internal credit risk rating practices at 10 Australian banks. The survey is a response to international proposals to develop more risk sensitive capital adequacy requirements utilising banks’ internal credit risk ratings. It examines various elements of the Australian banks’ internal credit risk rating systems, including the systems’ basic architecture, operating design and applications. Comparisons of the survey findings with those from similar international surveys are also provided. JEL Classification Numbers: G21 Keywords: Credit Risk Rating,APRA,Australia, Banks Table of Contents 1 INTRODUCTION 3

2 OVERVIEW OF INTERNAL CREDIT RISK RATING SYSTEMS 5 2.1 SYSTEM ARCHITECTURE 5 2.2 OPERATING DESIGN 7 2.3 APPLICATIONS 8 3 CREDIT RISK RATING AT AUSTRALIAN BANKS 9 3.1 ARCHITECTURE OF AUSTRALIAN BANKS’ CREDIT RATING SYSTEMS 9 3.1.1 LOSS CONCEPT 9 3.1.2 NUMBER OF RISK GRADES 11 3.1.3 DISTRIBUTION OF EXPOSURES AMONG RISK GRADES 14 3.1.4 POINT-IN-TIME VS THROUGH-THE-CYCLE GRADING 15 3.2 OPERATING DESIGN FEATURES 16 3.2.1 EXPOSURES RATED 16 3.2.2 CUSTOMER PD RATINGS 16 (i) TYPES OF RATING PROCESSES 16 (ii) KEY RATING RISK FACTORS 18 (iii) LINK TO QUANTITATIVE DEFAULT STATISTICS 18 3.2.3 FACILITY LGD RATINGS 20 3.2.4 SYSTEM OVERSIGHT AND CONTROL PROCESSES 21 3.2.5 VALIDATION PROCEDURES 22 3.3 RATING APPLICATIONS 23 4 CONCLUDING REMARKS 25 APPENDIX 1:TYPES OF CREDIT RISK RATING MODELS 27 APPENDIX 2: EXAMPLE TWO-DIMENSIONAL CREDIT RISK RATING MATRIX 29 REFERENCES 30 APRA DECEMBER 20002 1 INTRODUCTION Credit risk rating has become an important feature of most Australian banks’ credit risk management systems over the past decade. This reflects the efforts of institutions to strengthen credit management practices following the asset quality problems of the late 1980s/early 1990s, wider availability and growing familiarity with rating techniques of increasing sophistication within the industry, and a growing array of uses to which ratings may be applied. The Australian Prudential Regulation Authority (APRA) – as well as its predecessor as banking supervisor, the Reserve Bank of Australia – has also sought to encourage the use of credit rating systems, including through prudential guidelines originally issued to banks in 1995 and recently updated to apply to authorised deposit-taking institutions more generally. 1 This paper surveys the internal credit risk rating systems currently utilised by Australian banks and compares local rating practices with those found internationally. The main motivation for the paper stems from proposals that have been put forward by the Basel Committee on Banking Supervision for the reform of international bank capital adequacy guidelines, aimed at increasing the sensitivity of regulatory capital requirements to differences in institutions’ individual risk profiles. The Committee has recommended that, in conjunction with a new standardised approach to capital adequacy regulation, an internal ratings based approach could also form the basis for determining regulatory capital charges. The approach would link banks’ credit risk capital requirements to internal credit risk ratings for those institutions with suitably robust and well-developed risk rating systems that are able to meet minimum supervisory standards. 2 The Committee’s recommendation...

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