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Rating System Dynamics and Bank-Reported Default Probabilities under the New Basel Capital Accord

by Erik Heitfield of the Federal Reserve Board

April 1, 2004

Abstract: This paper uses a stylized model of credit rating systems to examine the interaction between a bank's rating philosophy and the default probabilities (PDs) it will be required to report under new regulatory capital standards being developed by the Basel Committee on Banking Supervision (Basel II). I show that the process of assigning obligors to rating grades and then estimating long-run average pooled PDs for each grade prescribed by the Basel Committee does not draw a direct link between the actual likelihood of default associated with an individual obligor and the pooled PD associated with the grade to which the obligor is assigned. As a result, the dynamic properties of the PDs assigned to obligors under Basel II depend on a bank's rating philosophy. This finding has implications for the cyclicality of regulatory capital requirements. Capital requirements for banks that adopt point-in-time rating systems can be expected to be more cyclical than those for banks that adopt through-the-cycle rating systems. It also has implications for the supervisory validation of the pooled PDs that banks report. Accurately benchmarking pooled PDs across banks will require that supervisors account for differences in rating philosophies. Backtesting pooled PDs against observed default frequencies will be most effective when banks adopt point-in-time rating systems.

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