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Managing Risks in Commercial and Retail Banking by AMALENDU GHOSH

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CHAPTER 10

Credit Risk Rating Models

10.1 INTERNAL RATING SYSTEMS IN BANKS

In 1999, after surveying banks’ internal rating systems and processes in about 30 institutions across G-10 countries, the Model Task Force of the Basel Committee on Banking Supervision, brought out the similarities and the differences in the structure, methodology, and application of internal rating systems at the banking institutions.1 The Task Force found the following common elements in the rating systems:

1. Commonality of risk factors for compilation of ratings, though differences existed in assigning relative importance to these risk factors and in deciding the mix between quantitative and qualitative factors.

2. Prevalence of both one-dimensional and two-dimensional rating systems among banking institutions, though the majority of them assigned ratings based on the assessment of the counterparty.

3. Similarity in purposes for utilizing information from the rating that included management reporting, pricing, and limit setting.

The Model Task Force found three main categories of rating processes in banks.2 One of these processes was a “statistical-based process,” which used both quantitative and qualitative risk factors, and the default probability or other quantitative tools to determine the rating of the counterparty. In developing this type of model, the bank first identified financial variables that provided information about the probability of default, and then by using historical data, the bank ...

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