Credit Risk

We’ve seen a variant of this issue in US/Canada, with the large Canadian Banks generally having IRB approval at the Group level (including for their main US loan books) and their US subsidiaries being on standardized

In this case, there is no incentive for the US entity to seek IRB approval - but US regulators do care about the risk rating systems from a bank supervision perspective, which has raised some of the same questions about whether group models are suitable. Those banks have generally taken a view aligned to a previous poster, i.e., using local models for middle market and below, and trying to align to group models for larger companies and FI's

On the last point, I'll say that we've seen US regulators challenge the support for those decisions heavily, but at least in some cases it seems to have stood up to that challenge.  In one case where the bank's prior analysis and documentation didn't provide great support, they are being pushed to redevelop those as well, though they are trying to do so in a way that they can ultimately extend back to group as well, for a C&I model that was getting a bit long in the tooth anyway

I'll just flag that a Canadian bank who had decided to extend several of their existing "global" models to their US subsidiary based on similar logic, and while the logic makes sense broadly, they ran into significant issues with their US subsidiary’s regulator about the way they did it

I would primarily attribute the root causes of those issues to:

Operating model for how those decisions were taken and where they were reviewed and challenged – the Group development and validation teams led the substantive assessment of “fit-for-use”, and while there were some US stakeholders involved, the ones most involved were not very senior in stature, and often deferred to the expertise of Group.  But those US stakeholders then couldn’t / didn’t do a good job of credibly defending those decisions to their regulators, leading the regulators to question if US senior management had been sufficiently involved in determining that these models were appropriate for the US portfolio

The documentation they produced justifying and validating the use of these models in the US was a narrow “fit for use assessment”, which taken as a standalone artifact fell far short of the comprehensive model documentation and validation expectations of SR 11-7.  This led regulators to question the “effective challenge” provided by US model risk management and more broadly by US senior management

Thanks a lot, this was very helpful!

Very interesting point. Would be great to know OW's experience with feedback from other players.

I suspect the answer will depend on what regulators require – for example the PRA expects all FIRB firms to use effective maturity (there’s currently a carve-out for SMEs, but they want to remove that too under Basel 3.1 – see below)

I have to admit, I cannot recollect what ECB/ EBA has had to say about this, but I think it would be pretty hard to justify using it in most places but not some – would very much feel like a bank would be open to challenge around whether it was cherry-picking

PRA CP16/22 proposal around Effective Maturity

4.305 The PRA currently specifies within IRB permissions that firms using the
FIRB approach must calculate effective maturity rather than apply fixed
parameters. This is because the PRA considers that calculation of effective
maturity is a more risk-sensitive approach, which better reflects the economic
substance of the exposures, and thus enhances the safety and soundness of firms.
Furthermore, using effective maturity facilitates effective competition because
firms using the AIRB approach are also required to apply the effective maturity
approach.

4.306 The PRA proposes to maintain the substance of its existing approach and
that firms using  the FIRB approach would continue to be required to apply the
effective maturity approach. The PRA proposes to include this provision in its
rules as it considers this would be more appropriate than applying the
requirement on a firm-by-firm basis as is currently the case.

4.307 The PRA considers that the proposed approach is in line with the Basel 3.1
standards as these include a discretion for national supervisors to require
firms using the FIRB approach to calculate effective maturity for all exposures.

4.308 Similarly, to improve risk-sensitivity, the PRA proposes to remove the
option currently setout in the CRR that allows firms that are otherwise
calculating maturity to instead apply fixed maturity values for exposures to
small UK corporates.

The other C&I related criteria I have seen for segmentation (may or may not be captured by your size / sector view):

Rated / quoted vs. not (on the basis these firms have access to additional sources of funding plus an extra source of predictive info, although that can be reflected by other mechanisms) Specialised lending vs not (Basel has some rules re: when should be viewed as specialised – to some extent it comes down to legal form) Legal form e.g. limited liability vs. partnership vs sole trader (at bottom end) Leverage finance / recent transaction e.g. divestiture, M&A … (on the basis that they are more sensitive to changes and historical performance data may be less relevant

Might also be worth taking a look at the detail in sections 2.5.5.1 - 2.5.5.2 dealing with customer migrations and migration matrix stability respectively, in the ECB's Instructions for reporting the validation results of internal models, pgs. 23 - 24

A number of UK banks have their wholesale PD models produce both “TTC” and “PIT” ratings – with the latter typically being driven by some sort of adjustment based on Moody’s KMV EDF’s or equivalents – you also have a number of other banks that for IFRS 9 will apply macro-economic model outputs on top of a largely TTC rating model to produce a PIT PD for IFRS 9 provisioning/ allowances purposes. The dual rating approach at big UK banks was heavily driven by a couple of modellers by the names of Scott Aguais and Lawrence Forest, and they have published a few papers describing their approach.

On the question of splitting by “investment Grade” vs “non-investment grade”, I’ve never seen this, although a split between leveraged and non-leveraged is common historically (when we built the model for one of the large German banks, we were able to reintegrate them). But size r whether a customer is rated/ quoted/ listed is a common basis for segmentation in the commercial space.

For EU banks, qualitative questions still tend to be included, although people are working to make them objective where possible, but not sure many have entirely removed them (again Scott Aguais was wanting to do this for one of the big UK banks – not sure whether he succeeded) – the issue with qualitatives is whether you can find the sweet-spot – at bottom end SME, often I don’t think credit officers have any real insights into their customers given how many they cover; at top-end, question is whether the credit officer has real insight beyond what can be captured by tools such as Factiva Sentiment Signals

Historically, it has been difficult to remove size segmentation from the entire corporate customer base, in part because you tend to see some factors have different relationships for small vs large firms (e.g. you might want a fair bit of cash on balance sheet of an SME, but for a large firm, this would be inefficient and you’d perhaps worry if management wasn’t trying to make their cash work hard )

Airplanes are ships of the sky from an LGD perspective, but not from a PD perspective. Railcars are also ships of the land by the same token

From a PD perspective, they are generally separate. The maritime companies and airlines have very different obligor dynamics

From an LGD perspective, the main drivers are downtime (i.e. how long the asset sits idle after a default) and shortfall (i.e. the decrease in the new lease after a default since usually periods of default coincides with pressure on asset prices and lease rates), but not the value on the plane. It is seldom that you’d actually lose the asset in any meaningful way, so that does not affect the LGD. There are international treaties that lessors would seek the jurisdiction of the lessee be a part of, before sending an expensive plane over with a long lifetime left on the asset. The other jurisdictions get the older planes where the lessor does not care all that much, whether they get it back or not

To be clear, you’d parameterize the LGD model differently for different assets as the downtime and shortfall dynamics are different. But the model structure is the same. So, it becomes a bit of an optical choice on whether you call that a single model or not

This may just be a rumour and so worth trying to Google to verify it, but I recall a long time ago that the MKMV model didn’t work well for banks, this was a known shortcoming of the model

It’s not at all clear what other type of structural model (other than something like KMV) one could even attempt for a bank…

Hi there,

Based on previous experience, for PD this is often not relevant: PDs are 12-month and the seasoning tends to be generally captured by the scoring model itself. A qualitative explanation of each scoring model and which characteristics it is considering that relate to seasoning may be enough, especially if complemented with quantitative analyses on the seasoning effect.

For a more quantitative approach, suggest testing time since origination and time until maturity as potential risk drivers using the general risk driver assessment framework during PD calibration - in the past I've observed this not to be significant but again, this is anecdotal evidence.

On LGD it may be relevant. However it should be understood that seasoning actually correlates with other significant risk drivers, particularly LTV and outstanding exposure amount. Here a deeper analysis of these parameters' significance should help "paint the broader picture".

Regards

A couple of thoughts on this subject, from one of our experts:

The discrepancy is caused by the adjustment implicitly assuming that a Bank would have had more defaults and lower scores (and so a worse average score) – while applying the theorem to a population which still has the same set of defaulted cases. This means the average scores are not worse, and hence you predicted PD will be lower.

There are at least two approaches to deal with this effect:

Adjust the constant term in the logistic until it hits the 2% target Run a “goal seek analysis" so that the average PD after mapping scores to the Bank grades, and applying the appropriate post-rating adjustments so the PD reaches 2%

Especially for European banks IRB models are actually required to be quite conservative unless Banks have "perfect" data, so the long-run average can become a moot point to a certain extent

On the topic of perfect data: if the Bank has enough data and the PD model is really powerful, it should find that there is no straight-line relationship between PD from logistic model vs. observed default rate. This is actually caused by the fact that whilst the errors are broadly normally distributed in logOdds space, when the distribution is converted to PD/default rate space the expectation will be closer to the mean than the original prediction.