Prudential Regulation Authority Rulebook

17.1

The PRA expects a firm to have a validation process that includes the following:

1. (a) standards of objectivity, accuracy, stability and conservatism that it designs its ratings systems to meet and processes that establish whether its rating systems meet those standards;
2. (b) standards of accuracy of calibration (ie whether outcomes are consistent with estimates) and discriminative power (ie the ability to rank-order risk) that it designs its rating systems to meet and processes that establish whether its rating systems meet those standards;
3. (c) policies and standards that specify the actions to be taken when a rating system fails to meet its specified standards of accuracy and discriminative power;
4. (d) a mix of developmental evidence, benchmarking and process verification and policies on how this mixture varies between different rating systems;
5. (e) use of both quantitative and qualitative techniques;
6. (f) policies on how validation procedures are expected to vary over time; and
7. (g) ensuring independent input into and review of its rating systems.

(CRR Article 185)

17.2

In the paragraph above:

1. (a) developmental evidence means evidence that substantiates whether the logic and quality of a rating system (including the quantification process) adequately discriminates between different levels of, and delivers accurate estimates of PD, EL, LGD and CFs (as applicable); and
2. (b) process verification means the process of establishing whether the methods used in a rating system to discriminate between different levels of risk and to quantify PD, EL, LGD and CFs are being used, monitored and updated in the way intended in the design of the rating system.

(CRR Article 185)

17.3

The PRA expects a firm to be able to explain the performance of its rating systems against its chosen measure (or measures) of discriminative power. In making this comparison a firm should rely primarily on actual historic default experience where this is available. In particular, the PRA expects a firm to be able to explain the extent of any potential inaccuracy in these measures, caused in particular by small sample size and the potential for divergence in the future, whether caused by changing economic conditions or other factors. Firms’ assessment of discriminative power should include appropriate use of external benchmarks where available.

17.4

The PRA expects that a firm establishing compliance with CRR Article 185 for residential mortgage rating systems should be able to demonstrate that its monitoring includes at least the following:

1. (a) an assessment of whether each long-run average PD remains appropriate to the population it is applied to, including whether movements in default rate are due to external factors or changes in underlying credit quality. The PRA would expect to see consideration given to internal firm historical data, industry data and economic data in assessing this;
2. (b) an assessment of the rating system’s cyclicality; and
3. (c) an assessment of the performance of any underlying rank-ordering or segmentation mechanism.

17.5

When applying for permission for either a new residential mortgage PD rating system or a material change to an existing rating system, the PRA expects firms to submit a completed monitoring management information pack in support of their application.

17.6

The PRA will take into consideration the sophistication of the measure of discrimination chosen when assessing the adequacy of a rating system’s performance.

17.7

In the case of a portfolio for which there is insufficient default experience to provide any confidence in statistical measures of discriminative power, the PRA expects a firm to use other methods. For example, analysis of whether the firm’s rating systems and an external measurement approach, eg external ratings, rank common obligors in broadly similar ways. Where such an approach is used we would expect a firm to ensure it does not systematically adjust its individual ratings with the objective of making them closer to the external ratings as this would be counter to the philosophy of an internal rating approach. The PRA expects a firm to be able to explain the methodology it uses and the rationale for its use.