BRITISH BANKERS’ ASSOCIATION Results of BBA/ISDA/RMA IRB Validation Study BBA/ISDA/RMA Advanced IRB Forum Monika Mars London - June 23, 2003

 2 BRITISH BANKERS’ ASSOCIATION Agenda  Survey Approach & Participants  Background – Use of Ratings  Survey Findings  Conclusions and Implications

 3 BRITISH BANKERS’ ASSOCIATION Survey research and design Data collection, and analysis Report preparation Report presentation Interviews Jan – Feb 2003 June 19/23 Feb – Mar st Draft Mid March 2003 Final Report Draft – early May 4 th Quarter 2002 Survey Approach

 4 BRITISH BANKERS’ ASSOCIATION Survey responses covered all asset classes representing a diverse group of institutions

 5 BRITISH BANKERS’ ASSOCIATION  Survey Methodology & Participants  Background – Use of Ratings  Survey Findings  Conclusions and Implications Agenda

 6 BRITISH BANKERS’ ASSOCIATION Internal ratings are key to managing the business at most firms

 7 BRITISH BANKERS’ ASSOCIATION Most banks use “Master Scales” to compare ratings information across portfolios

 8 BRITISH BANKERS’ ASSOCIATION Default definitions, time horizons and alignment to external sources vary among institutions  The definition of default is not in all cases in line with the BASEL II definition – this is particularly the case for retail portfolios  Time horizons of one year are most common, however the estimate of a 1-year PD might be based on a multiyear sample  Some banks use more than one year as a time horizon while a few use less than a one year time horizon to estimate PD  A small number of banks estimate PDs over the life of the loan  Most participants align a “majority” of their ratings in the corporate asset class to an external source, while the majority don’t do this in the retail asset class

 9 BRITISH BANKERS’ ASSOCIATION  Survey Methodology & Participants  Background – Use of Ratings  Survey Findings  Conclusions and Implications Agenda

 10 BRITISH BANKERS’ ASSOCIATION Key Findings  Banks employ a wide range of techniques for internal ratings validation  Ratings validation is not an exact science  Expert judgment is of critical importance in the process  Data issues are centred around quantity not quality  Regional differences exist with respect to the validation of internal ratings  Defining standards for stress testing requires additional work

 11 BRITISH BANKERS’ ASSOCIATION Banks employ a wide range of techniques to validate internal ratings - key differences exist between corporate and retail ratings  Corporate Asset Class  Statistical models where the quantity of default data allows for strong estimation (particularly in middle market)  Expert judgment models for portfolios where default data is limited  Hybrid and/or Vendor models to complete the picture  Retail Asset Class  Statistical models are heavily relied upon due to the greater availability of internal data history

 12 BRITISH BANKERS’ ASSOCIATION A variety of model types are employed within each asset class Model TypeCorporate Middle Market Retail Statistical7423 Expert Judgement External Vendor 7217 Hybrid1075

 13 BRITISH BANKERS’ ASSOCIATION Models for bank and sovereign exposures extensively use external information and expert judgement  Ratings for bank exposure are mostly derived by benchmarking against external ratings as well as using expert judgment or hybrid models  Ratings for sovereign exposures are similarly derived by benchmarking against external ratings as well as using expert judgment  Published default statistics are used for PD estimation for both bank and sovereign exposures

 14 BRITISH BANKERS’ ASSOCIATION Most banks surveyed have a rating system for specialised lending in place but face major issues in its validation  A common theme is the lack of default data  Validation issues specific to specialised lending include:  differentiation of borrower and transaction,  definition of default (particularly the restructuring clause),  inconsistent data history,  and the time horizon of the model

 15 BRITISH BANKERS’ ASSOCIATION Rating validation is not an exact science  Even with the use of statistical techniques to assess model performance absolute triggers and thresholds are not used  There is no absolute KS statistic, GINI coefficient, COC or ROC measure that models need to reach to be considered adequate  Default statistics published by the major rating agencies are used differently from bank to bank depending on each bank’s assessment of the most appropriate use of the external data  Benchmarking against external ratings raises many issues including the “unknown” quality of external ratings, methodology differences, and the like

 16 BRITISH BANKERS’ ASSOCIATION The performance of statistical rating models is achieved through a number of different techniques

 17 BRITISH BANKERS’ ASSOCIATION Different triggers are used to evaluate the overall performance of expert judgement rating models

 18 BRITISH BANKERS’ ASSOCIATION A variety of techniques are employed for evaluating vendor models

 19 BRITISH BANKERS’ ASSOCIATION Expert judgement is essential in the validation process  Data scarcity prevents the use of statistical models for some asset classes: corporate, bank, sovereign, and specialised lending  Most respondents use judgemental overlay by rating experts (account officer, credit analyst) to confirm or modify the risk rating output of their assessment model (statistical, hybrid, vendor)  Large proportions of banks’ exposures are covered by expert-judgment type rating systems

 20 BRITISH BANKERS’ ASSOCIATION Most data issues centre around quantity of data available not the quality of the data  Most banks surveyed have initiated projects to collect the necessary data in a consistent manner across the institution to allow for statistical modelling in the future  The quantity of default data around large corporate, bank, sovereign, and specialised lending exposure classes is a real problem for most institutions  Institutions have begun data pooling initiatives for PD and LGD data, however there is scepticism as to whether these measures will solve the data quantity problem

 21 BRITISH BANKERS’ ASSOCIATION Clear regional differences exist with regard to internal ratings for corporate assets and their validation  Expert judgment models are used for large corporate portfolios, however the structure of the ratings differ significantly  In North America fixed weightings are not assigned for the factors to be assessed by the experts  In Europe specific weights for each factor are often set  Models based on equity market information (KMV) or balance sheet information (Moody’s RiskCalc) are used for corporate and middle market portfolios  In North America, these models tend to be an integral part of the rating and are used in conjunction with expert judgment in a hybrid approach  In Europe, these models are more likely to be used as a benchmark or a validation of the internal rating model

 22 BRITISH BANKERS’ ASSOCIATION Similar differences can be observed for the retail asset class  Statistical (scorecard) techniques for retail exposures tend to be product specific in the US and UK, while in Continental Europe the focus is on customer scores/ratings  US and UK scorecards are redeveloped more often than those on Continental Europe, where robustness of ratings and long-term stability factors are of higher priority  This often has direct implications for validation, as longer term more stable models tend to show – for example - lower GINIs than models using the latest available data

 23 BRITISH BANKERS’ ASSOCIATION More work needs to be done in defining standards for stress testing  There is currently no uniform approach regarding the type of stress testing undertaken, its frequency, or actions taken in response to stress testing results  At the moment, stress testing is performed on the portfolio level with risk ratings being a key input in stress testing scenarios for economic capital requirements  There is uncertainty around BASEL II requirements with respect to stress testing of rating model inputs – and also considerable debate as to its usefulness

 24 BRITISH BANKERS’ ASSOCIATION  Survey Methodology & Participants  Background – Use of Ratings  Survey Findings  Conclusions and Implications Agenda

 25 BRITISH BANKERS’ ASSOCIATION The industry, regulators and other stakeholders must continue a dialogue to address Basel II implementation issues  Recognition of different techniques for validating internal rating systems – no one “right” method  Increased debate and guidance with respect to validation of expert judgement based rating systems  Recognition of regional / cultural differences as they impact internal ratings and the consequences for validation  Guidance on requirements for the use of pooled data  Additional discussion and clarification with respect to stress testing requirements

 26 BRITISH BANKERS’ ASSOCIATION