Thresholds for Ratings' Forecast Default Probabilities: A mean squared error based approach
by Guido Bichisao of the European Investment Bank,
December 12, 2005
Abstract: Given the increased importance rating agencies have assumed in the determination of credit institutions' capital requirements according to the Standardised Approach in the Basel II framework, the Basel Committee for Banking Supervision has proposed a procedure to "map" the ratings of different rating agencies into the risk weights that determine credit institutions' capital requirements. This procedure is built upon Cumulative Default Rates (CDRs) and is based for each rating class on reference values and upper admissible thresholds for observed CDRs. In fact, whenever the upper thresholds are exceeded, supervisors are encouraged to enquiry over the rating agencies' rating assignment standards. Thresholds are calculated on the basis of Monte Carlo simulations and assigned using the 99th and the 99.9th percentile of the distribution so obtained.