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Internal Ratings Systems, Implied Credit Risk and the Consistency of Banks' Risk Classification Policies

by Tor Jacobson of Sveriges Riksbank,
Jesper Lindé  of Sveriges Riksbank, and
Kasper Roszbach of Sveriges Riksbank

August 5, 2005

Abstract: Although much research has been done on external ratings, much less is known about banks´ internal ratings. This paper aims at improving our understanding of internal risk rating systems at large banks and the way in which they are implemented, to verify if they will provide regulators with a consistent picture of banks' loan portfolio credit risk, as is envisioned in the Basel II Accord. An important property of our work is that we derive our measures of credit risk without making any assumptions about correlations between loans, due to the fact that the size of the data allows us to apply Carey's [16] non-parametric Monte Carlo re-sampling method.

We find that default risk is most likely not homogeneous within rating classes, as regulators would expect it to be. Our results also reveal substantial differences between the implied loss distributions of the two banks with equal "regulatory" risk profiles; both expected losses and the credit loss rates at a wide range of loss distribution percentiles vary considerably. Such variation is likely to translate into different levels of required economic capital. As a result, incentives could transpire for some banks to securitize part of their loan portfolio to reduce costs, as happened under the Basel I Accord, or to change the risk profile of their loan portfolio to generate higher returns.

Our results also confirm that not only the design of a rating system itself, but also a portfolio's rating grade composition, the size of a bank, the preferred level of insolvency risk for a bank and the forecast horizon are quantitatively important for the shape of credit loss distributions and thus for banks required capital structure. With common portfolio parameters credit risk can, for example, be reduced by up to 40 percent by doubling portfolio size. This make clear that the calibration of the Basel risk weight mappings and banks' internal borrower risk rating systems are not yet synchronized in a way that they result in consistent estimates of portfolio credit risk for regulators.

JEL Classification: C14, C15, G21, G28, G33.

Keywords: Internal ratings, credit risk, tails, Value-at-Risk, banks, Basel II.

Published in: Journal of Banking & Finance, Vol. 30, No. 7, (July 2006), pp. 1899-1926.

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