Title: Presenters
1The Professional Risk Managers International
Association
- Presenters
- Roger Kumra,
- Vivian Ozohili,
- Conn ODonnell
- iesteering_at_prmia.org
2A look at the dynamics of rating systems An
overview of the CEBS approaches moving into
the discussion
3A look at the dynamics of rating systems
4Dynamics of Rating Systems
- Models can be split into
- Point-in-Time (PIT) models
- where the model is designed so that predicted PD
is expected to be close to the actual default
rate, in any given year - Could include factors such as Current Months
Arrears or factors that pick up changes in the
economic climate.
5Dynamics of Rating Systems
- Models can be split into
- Through-the-cycle (TTC) models
- where the model is designed so that the predicted
PD will be close to the average default rate over
the cycle, in any given year. - Could include factors such as LTV at Drawdown
which would remain static throughout the cycle.
6Dynamics of Rating Systems
- Most models usually fall in between the two
extremes. - These are called Hybrid Models
- The predicted PD follows the cycle only
partially.
7Grade Migrations PIT PD Shifts
The recessionary phase increases the likelihood
that capital requirements shoot up as a
consequence of borrowers downgrades. CEBS
Position paper on a countercyclical capital
buffer.
The PD of the portfolio would change over the
cycle as a result of the migration of borrowers
across grades and of the change of grade PDs.
CEBS Position paper on a countercyclical capital
buffer.
8Simplistic Model Build
- A hypothetical one factor model with two
attributes / questions - So each obligor / account falls into either
attribute 1 or attribute 2 - In a recession, the number of obligors in
attribute 1 decreases and the number of obligors
in attribute 2 increases
9Simplistic Model Build
- Hypothetical model, built using data from the
previous example, calibrated to an anchor point
of 4 and a cyclicality weight of 50 - PD
- 0.9 Attribute_1 21.2 Attribute_2
Calibrated to an Anchor Point of 4
10Result
- Predicted Default Rates move with the cycle
through time. - Therefore Capital Requirements also move through
time - In benign periods capital requirements are at
their lowest - Coming into a recessionary period we have the
effect of capital requirements increasing at a
time when funding is likely to be more scarce - Example Below 20 increase in capital
requirements from minimum to maximum.
11An overview of the CEBS approaches
12Pro-Cyclicality Options
- Two options proposed for the Implementation of
the Capital buffer - Portfolio level option
- PD Scaling option
- Time Varying Confidence Interval
- Rating-grade level (i.e. more granular) option
- One- Step PD Scaling Factor
- Two- Step PD Scaling Factor
- CEBS shares the view that any Capital Buffer
should be bank-specific
13Portfolio Level Option
- Part A PD Scaling option
- PD Scaling Factor for the portfolio ratio
between recessionary PD (highest PD) and current
PD - Current Portfolio PD
14Portfolio Level Option
- Key Issues -Current PD of portfolio will change
through the cycle - Grade Migration (more pronounced in PIT rating
systems - Change in Grade PD (more pronounced in TTC rating
systems)
15ILLUSTRATION - EXAMPLE
16Evolution of Buffer through the cycle
17 MCR VS. BUFFER
18MCR VS. BUFFER
19Portfolio Level Option
- Part B Time Varying Confidence Interval
- Buffer/Scaling factor determined using
Risk-Weight Function with Time-Varying Confidence
Intervals i.e. Stress Test of the capital
requirement to reflect economic conditions - Capital requirement (K) LGD N(1 R)-0.5
G(PD) (R / (1 R))0.5 G(0.999) PD x LGD - Calculate capital charge in Bad year (economic
downturn) using above formulae and adjust IRB
risk weight function upward in good years
(economic upswing).
20Rating-grade level (i.e. more granular) option
- Part A One Step Scaling Factor
- Scaling Factor/Buffer is determined for each
rating grade - Current PD Long run average 1- year default
rate in that Grade at time T. Downturn PD is
highest PD observed for Grade over a
predetermined time frame. - Approach is non-neutral with respect of rating
philosophy
21Rating-grade level (i.e. more granular) option
- Part B Two Step Scaling Factor- accounts for
Grade Migration. - Introduce when calculating current PD Calculate
Modified Current PD
22Rating-grade level (i.e. more granular) option
23Rating-grade level (i.e. more granular) option
- MOD PD (100 - 10 - 15) 5 102
1510 5.45 - So the modified PD for grade G is 5.45, compared
with the original PD for Grade G of 5. - Similarly Calculate Downturn Modified PD
24 moving into the discussion
25Summing up
- PDs produced by rating systems are cyclical
- Regardless of rating philosophy, we see
systematic fluctuations in PDs through the cycle - This leads to cyclical capital requirements
- CEBs have proposed a variety of approaches to
address this - These are based around the idea of a capital
buffer - PDs are scaled up the capital buffer is the
difference between the capital requirement using
normal PDs and scaled PDs - Different approaches focus on the portfolio as a
whole or on individual grades - Key assumptions/limitations of approach
- Changes in PD are due to cyclical effects
- Changes in portfolio composition are not
specifically addressed - The impact of increased realised defaults and
losses on capital are not explicitly addressed
26Issues to Explore
- Core Issues
- Impact on changes in portfolio composition
- Are these adequately taken into account?
- Are there incentives to decrease underlying
portfolio quality? (higher capital requirement
leads to higher costs less sensitivity to risk) - Robustness of scaling factor
- Do banks have sufficiently long time series?
- Whats the impact on changes to bank structures
or mergers how can these be taken into account? - Want measures that are robust through the cycle
does this limit the power of the approach? - Adverse incentives
- Can the approach create adverse incentives? Eg
holding higher risk assets that have risk not
captured by the approach
27Issues to Explore
- Interpretation and Use
- Interpretation of results
- Type of rating system (point in time vs through
the cycle) - What does the capital buffer mean
- Are there issues in justifying it to the Board?
- Use of buffer within business
- Are there Use-Test issues?
- Should information on the buffer be incorporated
into pricing? If so, how can this be done? - Use of the buffer by external parties
- Will rating agencies and external analysts expect
the buffer to be maintained through a down-turn?
28Issues to Explore
- Implementation
- Developing the ideas further
- Should the term of loans on the book be
considered? The shorter the term the more
flexibility the bank has (except maybe for
bullets refinanced by new loans). - Pillar 1 vs Pillar 2
- What are the advantages/disadvantages of holding
the buffer under either Pillar 1 or 2? - Comparison to Stress Testing
- Does this approach overlap with stress testing?
- What additional information does this approach
provide that stress testing doesnt? And
vice-versa?
29Issues to Explore
- What else should be considered?
- Its unlikely we have captured everything here.
- In addition, the approach doesnt look at the
actual increased defaults and increased LGDs that
would occur in a downturn. How might these be
incorporated? - What else would you like to discuss on this
topic?
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