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Basel
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the largest
association of Basel ii Professionals in the
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Basel Committee on Banking Supervision, The Joint Forum
Stocktaking on the use of credit ratings - June 2009
Appendix 2
Structural overview of Basel II
The different uses of external credit ratings
This section does not aim at being exhaustive but rather at
explaining the main usages of
ratings.
Pillar
I (Minimum Capital Requirements)
Credit risk
Credit ratings are widely used for the
calculation of capital charges for credit risk in order to
differentiate the exposures in a risk-sensitive manner and set the
capital charges accordingly.
External and/or internal ratings might be used under the revised
framework, but as a general principle, Basel II promotes the use
of internal ratings, in the context of the internal ratings based
approach.
Under the Internal-Rated based Approach,
the risk sensitivity of the regulatory capital requirements is
attained through the use of internally produced credit ratings
models for all the different exposures class (sovereign, bank,
corporate, retail and equity).
External ratings are not supposed to be used for the calculation
of capital charges (with the exception of securitisation exposures
�see below).
However, the implementation of the IRB approach might result in
some marginal indirect uses of external ratings; the main use is
within the area of models validation in, for instance,
benchmarking exercises.
Consequently, external ratings are primarily used in the context
of the standardised approach.
In the standardised Approach, the
risk sensitivity of the regulatory capital requirements is
attained through the recourse to external credit ratings for
exposures within the corporate, sovereign and bank exposure class.
Institutions may only use the external ratings provided by rating
agencies recognised by supervisors (see. Section 4 below), with
the exception of exposures to sovereign where banks might directly
use the ratings provided by export credit agencies.
In practice, the risk weights applied to sovereign, banks and
corporate exposures are differentiated according to the individual
external credit assessment of each exposures.
The Basel II framework provides tables that
pre-map regulatory determined risk-weights to sets of credit
ratings scales from authorised rating agencies, enabling the
simple determination of an exposure�s risk weight (tables mapping
external ratings and risk-weights are specific to each exposure
class).
For example, for corporate exposures, the risk weights applicable
might vary from 20 percent to 150 percent depending on the credit
assessment of the exposure (see table below), whereas under the
Basel 1 framework a 100% risk-weight was applied to all corporate
exposures.
Credit risk mitigation rules define how funded credit protections
(collateral) and unfunded credit protections (guarantees and
credit derivatives) can be recognised.
They are applicable to the standardised approach and to some
extent to the IRB foundation approach.
Credit risk mitigation rules refer to
authorised external ratings in order to:
� Identify the eligible credit protection (for example, only the
guarantees provided by an entity with a rating higher than a
predetermined threshold might be recognised)
� Adjust the extent of the recognition of the credit protection
(for example, haircuts proportionate to the credit quality of the
issuer are applied to collateral under the comprehensive
approach).
The securitisation framework differs from
the general credit risk rules in the way that both the
standardised and the IRB approach use authorised external credit
ratings.
� For banks using the standardised Approach,
the risk sensitivity of the regulatory capital requirements is
attained through the recourse to authorised external credit
ratings for the subset of authorised securitisation transactions.
� For banks using the Internal Ratings based
Approach, the risk sensitivity of regulatory capital
requirements is attained through the recourse to authorised
external credit ratings within the Ratings-based approach and to a
lesser extent within the Internal Assessment Approach, and through
a regulatory setting within the SF (Supervisory formula) when
credit ratings cannot be inferred.
The prescribed long term and short term tables that pre-map
regulatory determined riskweights to sets of credit ratings scales
from authorised ECAIs for the standardised and the IRB approaches
differ; the IRB table is more granular and its risk weights are
different from that of the standardised approach.
Market
risk
When considering market risk measurement, external ratings are
only used for the calculation of the specific risk capital charges
arising from debt position under the standardised approach for
market risk.
In a way similar to what is done within the frame of the credit
risk rule, different risk weights are applied to the trading book
debt positions according to the external ratings of the issuer.
The rules on specific risk also refer to a
notion of qualifying category, which is notably (but not only)
based on its turn on the fulfilment of attaining an
�investment-grade� credit rating from credit rating agencies.
Under the Internal Model Approach,
the risk sensitivity of regulatory capital requirements is
attained through the use of internally designed risk management
models that are subject to supervisory approval.
Given that these models usually focus on general market risk, the
treatment of the capital charge for the area of specific risk
measurement will be made separately if the internally designed
models do not encompass on top a modelling of specific risk.
A fallback on authorised external credit ratings is possible, or
else a broader treatment within the Incremental Risk Capital
charge.
Operational risk
Under all the different approaches used to measure operational
risk, there is no use of external ratings, with the exception of
the treatment of risk mitigation techniques in the Advanced
Measurement Approach (in line with the overall treatment of risk
mitigation techniques under the credit risk rules, the protection
provider must have a rating above a defined threshold).
Pillar II (Supervisory Review Process)
There is no specified use of external ratings in the context of
the Supervisory review process.
Pillar III (Market Discipline)
Pillar III requirements contain specific qualitative disclosure
requirements (among others) with respect to the use of external
credit assessment institutions (ECAIs) and Export Country Agency (ECAs).
� Credit Risk: Disclosures for
Portfolios subject to the standardised and supervisory risk
weights in the IRB approaches (see table 5 of the Revised
Framework).
Qualitative disclosure (a) Names of ECAIs and ECA used, types of
exposures for which each ECAI, ECA is used, alignment of
alphanumerical scale with each bucket or evidence of compliance
with the mapping published by relevant supervisors.
� Securitisation: Disclosure for
standardised and IRB Approaches (see table 9 of the Revised
Framework). Qualitative disclosure ( c ) Names of the ECAIs used
for securitisation and types of securitisation exposures for which
each agency is used.
Authorised external ratings and the notion of �ECAI� (External
Credit Assessment Institution)
Definition of ECAI and the principle of the �recognition�
External ratings that can be used for the capital purposes,
according to the Basel II framework, are limited to the ratings
provided by recognised External Credit Assessment Institutions (ECAI).
Supervisors are in charge of the recognition of ECAI.
The ECAI recognition process has two main
dimensions:
� Identification of the rating
agencies that provide external ratings suitable for capital
calculation purposes.
The BCBS has defined criteria in this respect (see. 4.1 below) and
supervisors are in charge of assessing whether those criteria are
satisfied by the rating agencies willing to be recognised as ECAI.
� Mapping of the external ratings to
the risk-weights (or credit quality steps in the EU CRD
implementation) defined by the Basel II framework (see. 4.2 below)
The ECAI recognition process does not constitute a form of
regulation of ECAIs by supervisors or a form of licensing of
rating agencies.
It simply aims at the determining the ratings that can be used by
banks, by ensuring that the ratings are appropriate for
supervisory and capital purposes.
Eligibility criteria
The key purpose of the recognition criteria is to identify rating
agencies that produce external credit assessments of sufficiently
high quality, consistency and robustness to be used by
institutions for regulatory capital purposes.
In order to achieve this goal, the Basel
Committee on banking supervision has defined criteria that should
be satisfied by rating agencies.
Paragraph 91 of the Basel II framework details those criteria:
�
Objectivity:
The methodology for assigning credit assessments must be rigorous,
systematic, and subject to some form of validation based on
historical experience.
Moreover, assessments must be subject to ongoing review and
responsive to changes in financial condition. Before being
recognised by supervisors, an assessment methodology for each
market segment, including rigorous backtesting, must have been
established for at least one year and preferably three years.
�
Independence:
An ECAI should be independent and should not be subject to
political or economic pressures that may influence the rating.
The assessment process should be as free as possible from any
constraints that could arise in situations where the composition
of the board of directors or the shareholder structure of the
assessment institution may be seen as creating a conflict of
interest.
�
International access/Transparency:
The individual assessments should be available to both domestic
and foreign institutions with legitimate interests and at
equivalent terms.
In addition, the general methodology used by the ECAI should be
publicly available.
�
Disclosure: An
ECAI should disclose the following information: its assessment
methodologies, including the definition of default, the time
horizon, and the meaning of each rating; the actual default rates
experienced in each assessment category; and the transitions of
the assessments, eg the likelihood of AA ratings becoming A over
time.
�
Resources: An
ECAI should have sufficient resources to carry out high quality
credit assessments.
These resources should allow for substantial ongoing contact with
senior and operational levels within the entities assessed in
order to add value to the credit assessments. Such assessments
should be based on methodologies combining qualitative and
quantitative approaches.
�
Credibility: To
some extent, credibility is derived from the criteria above.
In addition, the reliance on an ECAI�s external credit assessments
by independent parties (investors, insurers, trading partners) is
evidence of the credibility of the assessments of an ECAI.
The credibility of an ECAI is also underpinned by the existence of
internal procedures to prevent the misuse of confidential
information.
In order to be eligible for recognition, an ECAI does not have to
assess firms in more than one country.
The
mapping process
Once it has been assessed that a rating agency meets the ECAI
recognition requirements, its credit assessments are �mapped� by
supervisors to the risk weights (credit quality steps)
defined by the Basel II framework, which in
turn determines the risk weight (amount of capital) to be applied
to each exposure.
The �mapping� is notably based on reference defaults rates (in
particular the 3-year cumulative default rates evaluated over the
long-term), which should ensure the stability of the mapping but
also an equivalent treatment of the ratings provided by the
various rating agencies.
European specific aspects
The uses of external ratings in the CRD (Capital Requirements
Directive - the European implementation of the Basel II framework)
is fully consistent with the international rules.
Nevertheless, two significant differences can be observed :
� in the context of the standardised
approach, external ratings can also be used to risk-weight
exposures to CIUs (Collective Investment Units).
Specific risk-weights are provided for this exposure class.
� The risk-weight tables, that link credit
assessment to risk-weight, are generally more granular.
The CEBS (Committee of European Banking Supervisors) issued in
January 2006 �Guidelines on the recognition of External Credit
Assessment Institutions� which:
(i) Clarify the recognition process at the
European level, by :
� Defining a standard application form, that should be submitted
to supervisors by rating agencies willing to be recognised.
The content of the package should allow supervisors to assess the
application.
� Creating a joint assessment process, applicable to international
ratings agencies (or ratings agencies operating in more than one
country).
(ii) Present CEBS Common understanding of
the ECAI recognition criteria laid down in the CRD
A rating agency can become a recognised ECAI if a member state
supervisor determines that it meets the following criteria in one
or all of the three market segments (financial institutions,
corporate (includes public sector) and securitisations:
� Objectivity � methodology for assigning credit assessments is
systematic, rigorous, continuous, and subject to validation.
� Independence � factors taken into account include ownership and
organisational structure, financial resources, staffing and
expertise, and corporate governance.
� On-going review � responsive to changes in financial conditions
and reviewed at least annually.
� Transparency & disclosure � methodologies need to be public so
users can decided whether they are derived in a reasonable way.
In addition their credit assessments had to be:
� Credible and accepted by the market � market share, revenues,
whether pricing is on the basis of credit assessments.
� Transparent & disclosed - credit assessments need to be
available on an equivalent basis.
(iii) Precise the qualitative and
quantitative factors that should be used by supervisors when
mapping external ratings and regulatory credit quality steps.
Go
to
Stocktaking on the use of credit ratings - June 2009 Part 6
Basel Committee on Banking Supervision, The Joint Forum
Stocktaking on the use of credit ratings - June 2009 Part 1
Stocktaking on the use of credit ratings - June 2009 Part 2
Stocktaking on the use of credit ratings - June 2009 Part 3
Stocktaking on the use of credit ratings - June 2009 Part 4
Stocktaking on the use of credit ratings - June 2009 Part 5
Stocktaking on the use of credit ratings - June 2009 Part 6
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