Prudential Regulation Authority Rulebook

10.1

In order to be able to determine that the requirements in CRR Article 144(1) have been met, the PRA would typically have the high level expectations set out in this subsection.

10.2

The PRA expects the information that a firm produces or uses for the purpose of the IRB approach to be reliable and take proper account of the different users of the information produced (customers, shareholders, regulators and other market participants).

10.3

The PRA expects firms to establish quantified and documented targets and standards, against which it should test the accuracy of data used in its rating systems. Such tests should cover:

1. (a) a report and accounts reconciliation, including whether every exposure has a Probability of Default (PD), Loss Given Default (LGD) and, if applicable, conversion factor (CF) for reporting purposes;
2. (b) whether the firm’s risk control environment has key risk indicators for the purpose of monitoring and ensuring data accuracy;
3. (c) whether the firm has an adequate business and information technology infrastructure with fully documented processes;
4. (d) whether the firm has clear and documented standards on ownership of data (including inputs and manipulation) and timeliness of current data (daily, monthly, real time); and
5. (e) whether the firm has a comprehensive quantitative audit programme.

10.4

The PRA expects that in respect of data inputs, the testing for accuracy of data, including the reconciliation referred to above, should be sufficiently detailed so that, together with other available evidence, it provides reasonable assurance that data input into the rating system is accurate, complete and appropriate. The PRA considers that input data would not meet the required standard if it gave rise to a serious risk of material misstatement in the capital requirement, either immediately or subsequently.

10.5

In respect of data outputs, as part of the reconciliation referred to above, the PRA expects a firm to be able to identify and explain material differences between the outputs produced under accounting standards and those produced under the requirements of the IRB approach, including in relation to areas that address similar concepts in different ways (for example expected loss (EL) and accounting provisions).

10.6

The PRA expects a firm to have clear and documented standards and policies about the use of data in practice (including information technology standards) which should in particular cover the firm’s approach to the following:

1. (a) data access and security;
2. (b) data integrity, including the accuracy, completeness, appropriateness and testing of data; and
3. (c) data availability.

(CRR Article 144(1)(a))

10.6A

In order to be satisfied that the requirements in CRR Article 145 are met, the PRA expects firms to be able to evidence that:

1. (a) its complete IRB governance framework has been through at least one annual cycle since internal approval;
2. (b) it has used its internal rating systems in credit decisions, lending policies, risk appetite polices and credit risk monitoring for at least three years; and
3. (c) there has been at least three years of monitoring, validation and audit of the IRB framework, recognising that the IRB framework is likely to be subject to development and refinement during this period.

10.6B

The three years of evidence of using internal rating systems set out in 10.6A(b) need not necessarily relate to the use of the final, fully CRR compliant framework for all of that period. It could, for example, initially involve the use of internal credit risk models which are broadly in line with CRR requirements rather than the final, fully compliant, IRB rating systems. At approval however, applicants would be expected to have undertaken at least one annual review cycle of the completed framework.

10.6C

The depth and detail of the monitoring, audit and annual reviews set out in 10.6A(c) may be proportionately lower at the start of the three year period, provided that firms provide a sufficiently accurate analysis of progress, and fully meet the required standard by the end of the three year period. The monitoring of rating systems may include the use of provisioning models, scorecards, and rating assignment processes.

10.6D

The PRA will not accept evidence of a third-party exercising governance of models (eg bureau scores monitored by the bureau) as evidence of a firm’s ability to monitor the models itself.

(CRR Article 145)

10.7

In order for the PRA to be satisfied that a firm documents its ratings systems appropriately in accordance with CRR Article 144(1)(e) the PRA expects a firm to be able to demonstrate that it has an appropriate policy in respect of its ratings systems in relation to:

1. (a) any deficiencies caused by its not being sensitive to movements in fundamental risk drivers or for any other reason;
2. (b) the periodic review and action in the light of such review;
3. (c) providing appropriate internal guidance to staff to ensure consistency in the use of the rating system, including the assignment of exposures or facilities to pools or grades;
4. (d) dealing with potential weaknesses of the rating system;
5. (e) identifying appropriate and inappropriate uses of the rating system and acting on that identification;
6. (f) novel or narrow rating approaches; and
7. (g) ensuring the appropriate level of stability over time of the rating system.

(CRR Article 144(1)(a) and 144(1)(e))

10.8

In order to be satisfied that the requirements in CRR Article 179(1) are met, the PRA expects a firm to collect data on what it considers to be the main drivers of the risk parameters of PD, LGD, CF and EL, for each group of obligors or facilities, to document the identification of the main drivers of risk parameters, and to be able to demonstrate that the process of identification is reasonable and appropriate.

10.9

In its processes for identifying the main drivers of risk parameters, the PRA expects that a firm should set out its reasons for concluding that the data sources chosen provide in themselves sufficient discriminative power and accuracy, and why additional potential data sources do not provide relevant and reliable information that would be expected materially to improve the discriminative power and accuracy of its estimates of the risk parameter in question. The PRA would not expect this process necessarily to require an intensive analysis of all factors.

(CRR Article 179(1)(a), 179(1)(d) and CRR Article 179(1)(e))

10.10

In order to demonstrate that rating systems provide for meaningful assessment, the PRA expects that a firm’s documentation relating to data include clear identification of responsibility for data quality. The PRA expects a firm to set standards for data quality, aim to improve them over time and measure its performance against those standards. Furthermore, the PRA expects a firm to ensure that its data are of sufficiently high quality to support the firm’s risk management processes and the calculation of its capital requirements.

(CRR Article 144(1)(a))

10.11

Further detail of standards that the PRA would expect firms to meet when it assesses compliance with CRR Article 174 are set out in the sections on PD, LGD and Exposure at Default (EAD).

10.12

In assessing whether the external data used by a firm to build models are representative of its actual obligors or exposures, the PRA expects a firm to consider whether the data are appropriate to its own experience and whether adjustments are necessary.

(CRR Article 174 and 174(c))

10.13

In order to estimate PDs that are long-run averages of one year default rates for obligor grades or pools, the PRA expects firms to estimate expected default rates for the grade/pool over a representative mix of good and bad economic periods, rather than simply taking the historic average of default rates actually incurred by the firm over a period of years. The PRA expects that a long-run estimate would be changed when there is reason to believe that the existing long-run estimate is no longer accurate, but that it would not be automatically updated to incorporate the experience of additional years, as these may not be representative of the long-run average.

10.14

In order to calibrate a long-run average PD for UK residential mortgages, the PRA expects that in defining a representative mix of good and bad economic periods (as referred to in paragraph 10.13 above) firms would need to incorporate economic conditions equivalent to those observed in the United Kingdom during the early 1990s. The PRA is setting this expectation in light of recent economic experience and may revise it in the future as appropriate.

10.15

CRR Article 180(1)(a) requires firms to estimate PDs by obligor grade from long-run averages of one-year default rates. However, for some types of residential mortgages (‘low historical data’) such as buy-to-let, self-certification and sub-prime, there may be an absence of or insufficient relevant internal or external data over a representative economic cycle. For such exposures, the PRA expects firms to model how book-level default rates in a given low historical data portfolio would have performed under the economic conditions that would be experienced in an economic cycle containing a representative mix of good and bad periods. The outputs of this model should then be used in order to calibrate long-run average PDs for each rating grade.

10.16

The PRA expects rating systems referred to in paragraph 10.15 above to result in long-run average PDs that include an appropriate margin of conservatism. For each low historical data mortgage portfolio, the PRA will undertake an assessment of whether the resultant degree of uplift in PDs relative to comparable mortgages in a firm’s prime portfolio is sufficient.

10.17

The PRA recognises that the amount of available data for non-UK mortgages varies by jurisdiction. Where a firm has insufficient internal or external data to calibrate long-run average PDs for these portfolios, it should apply the approach set out in paragraph 10.15. For each portfolio of non-prime non-UK mortgages, where the approach in paragraph 10.15 has been applied, the PRA will assess whether the degree of uplift in PDs relative to comparable mortgages in a firm’s prime portfolio for the jurisdiction in question is sufficient.

10.18

The PRA would not normally expect low historical data and prime portfolios to be combined within the same rating system as it is challenging for firms to demonstrate a meaningful differentiation of risk and accurate and consistent quantitative estimates of risk in such cases. In the event that a firm is able to demonstrate to the PRA that such an approach is appropriate, the PRA expects the low historical data sub-set of the rating system to meet the expectations contained within paragraphs 10.15-10.17.

10.19

The PRA expects that PDs for portfolios in run-off are calibrated to reflect how a firm’s existing portfolio would perform in an economic cycle containing a representative mix of good and bad periods. Where a firm has insufficient internal or external data to calibrate PDs the techniques outlined in paragraph 10.1 should be applied.

(CRR Article 180)

10.20

In order to be able to demonstrate compliance with CRR Article 144(1), the PRA expects a firm to take into account the following factors in understanding differences between their historic default rates and their PD estimates, and in adjusting the calibration of their estimates as appropriate:

1. (a) the rating philosophy of the system and the economic conditions in the period over which the defaults have been observed;
2. (b) the number of defaults, as a low number is less likely to be representative of a long-run average. Moreover, where the number of internal defaults is low, there is likely to be a greater need to base PDs on external default data as opposed to purely internal data;
3. (c) the potential for under-recording of actual defaults; and
4. (d) the level of conservatism applied.

10.21

The PRA expects recalibrations of rating systems applying the cyclicality assumptions set out in paragraph 12.4 to be rare and to be symptomatic of failures of the rating system’s assumptions rather than part of rating system design. For these purposes any calculation mechanism embedded in a rating system that changes the PD applied to exposures with a given set of characteristics should be treated as a recalibration. The PRA expects that any recalibration of such a rating system would include:

1. (a) a robust assessment of the cyclicality of the rating system;
2. (b) a robust assessment and explanation of the cause of the need to recalibrate, including whether it is due to changes in default risk that are not purely related to changes in the cycle. This should include an assessment of the firm’s own lending profile, its historical performance, wider industry performance against historical levels and changes in economic factors; and
3. (c) a review of the appropriateness of undertaking a recalibration by an independent validation function.

(CRR Article 144(1))

10.22

The PRA expects that a firm that is not able to produce a long-run estimate, as described above, to consider what action it would be appropriate for it to take to comply with CRR Article 180(1)(a). In some circumstances, it may be appropriate for firms to amend their rating system so that the PD used as an input into the IRB capital requirement is an appropriately conservative estimate of the actual default rate expected over the next year. However, such an approach is not likely to be appropriate where default rates are dependent on the performance of volatile collateral.

(CRR Article 179(1)(f) and 180(1)(a))

10.23

In accordance with CRR Article 181(1)(b) and CRR Article 182(1)(b), where the estimates appropriate for an economic downturn are more conservative than the long-run average, we would expect the estimate for each of these parameters to represent the LGD or CF expected, weighted by the number of defaults, over the downturn period. Where this was not the case we would expect the estimate to be used to be the expected LGD or CF, weighted by the number of defaults, over a representative mix of good and bad economic periods.

(CRR Article 179, 181 and 182)

10.24

In order to demonstrate that a rating system provided for a meaningful differentiation of risk and accurate and consistent quantitative estimates of risk the PRA expects that a firm would have regard to the sensitivity of the rating to movements in fundamental risk drivers, in assigning exposures to grades or pools within a rating system.

(CRR Article 171)