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30The application of system of internal ratings in assessment of credit risk of long-term
financing in Russian banks Saribekian K. (Russian Federation)
Применение системы внутренних рейтингов при оценке рисков долгосрочного
кредитования в российских банках Сарибекян К. А. (Российская Федерация)
Сарибекян Карен Альбертович /Saribekjan Karen - бакалавр экономики, магистрант, кафедра финансового менеджмента,
Финансовый университет при Правительстве Российской Федерации, г. Москва
Abstract: this article examines the aspects of application of internal ratings system at commercial banks. It is explained why the system of internal rating makes credit risk management more effective.
Аннотация: в данной статье рассмотрены наиболее существенные аспекты применения системы внутренних рейтингов в коммерческом банке. Описываются принципы использования внутренних рейтингов для эффективного управления кредитным риском.
Keywords: система внутренних кредитных рейтингов, управление кредитным риском, кредитный анализ, управление кредитным портфелем.
Ключевые слова: internal credit ratings, banking, credit risk management, credit analysis, loan portfolio management.
Internal credit risk rating systems are becoming an increasingly important element of large commercial banks’ measurement and management of the credit risk of both individual exposures and portfolios.
Internal credit ratings are an increasingly important element of credit risk management at large banks. Their credit-related businesses have become progressively more diverse and complex and the number of their counterparties has grown rapidly, straining the limits of traditional methods of controlling and managing credit risk. In response, many large banks have introduced more structured or formal systems for approving loans, portfolio monitoring and management reporting, analysis of the adequacy of loan loss reserves or capital, and profitability and loan pricing analysis. Internal ratings are crucial inputs to all such systems as well as to quantitative portfolio credit risk models.
The Central Bank of Russia has recently published the legislation on the adoption of the Advanced Internal Ratings Based (AIRB) for Credit Risk. There is some ambiguity in the Russian banking sector with regards to costs and benefits of adopting the new rules. In the long-term, transition to the AIRB approach is likely to allow Russian banks to have lower capital requirements due to a more granular approach to risk assessment and greater risk sensitivity. Adopting the AIRB rules could also give a positive signal to the market about increased reliability of risk systems and processes, thus improving bank’s reputation and potentially decreasing its funding costs. However, transition to the new rules will be rather challenging for some Russian banks.
Like a public credit rating produced by agencies such as Moody’s or Standard & Poor’s, a bank’s internal rating summarizes the risk of loss due to failure by a given borrower to pay as promised. However, banks’ rating systems differ significantly from those of the agencies, partly because internal ratings are assigned by bank personnel and are usually not revealed to outsiders. Batter use of internal ratings can help banks manage transitions to more complex and demanding risk management. Basel Committee is beginning to consider proposals to make international bank capital standards more sensitive to differences in portfolio credit risk, and internal ratings play a key role in several such proposals. Regulatory reliance on internal ratings would introduce new and powerful stresses on banks’ internal rating systems which, if not addressed, could disrupt credit risk management at many banks. The specifics of internal rating systems currently differ across banks. The number of grades and the risk associated with each grade vary, as do decisions about who assigns ratings and about the manner in which rating assignments are reviewed. To a considerable extent, such variations are an example of form following function. Banks in different lines of business or using internal ratings for different purposes design and operate different systems that meet their needs. For example, a bank that uses ratings mainly to identify deteriorating or problem loans to ensure proper monitoring may and that a rating scale with relatively few grades is adequate, whereas a bank using ratings in computing the relative profitability of different loans may require a scale with many grades in order to achieve the distinctions of credit risk. As described by Altman and Saunders, much research on statistical models of debt default and loss has been published over the past few decades. Many banks use statistical models as an element of the rating process, but rating assignment and review almost always involve the exercise of human judgment. Because the factors considered in assigning a rating and the weight given each factor can differ significantly across borrowers, banks (like the rating agencies) generally believe that the current limitations of statistical models are such that properly managed judgmental rating systems deliver more accurate estimates of risk. Especially for large exposures, the benefits of such accuracy may outweigh the higher costs of judgmental systems, and banks typically produce internal ratings only for business and institutional loans and counterparties.
Virtually all large Russian banks generate internal reports of total asset balances falling in the regulatory problem-asset grades, which are seen by senior management and boards of directors. About 80% also internally
report breakdowns of balances in each of their Pass grades. Pass grade breakdowns appear to be used either by management or credit staff as a means of detecting changes in portfolio mix, and are only infrequently shown to boards of directors. Balances in the regulatory grades give a sense of the share of bank assets that are troubled, whereas a profile of balances in Pass grades can provide a forward-looking sense of trends in the bank’s risk posture (as long as Pass grade assignments meaningfully distinguish risks). Internal reports are less likely to be informative when a large share of rated assets falls into only one or two Pass grades.
What are the benefits for financial institutions of introducing internal rating systems? First, such a system enables banks to efficiently make lending decisions and manage loans with less administrative work. Second, it makes it easier to grasp the creditworthiness of borrowers and the quality of credit transactions using a single yardstick. Moreover, the assessment of the credit quality of the entire portfolio becomes possible by monitoring changes in the amount of credit exposure and number of borrowers in each rating grade. It also becomes possible to quantify credit risk through estimation of the possibility of default by rating grade. These analyses with consistency, comprehensiveness, and objectivity should serve as the foundation of sound bank management.
Improvement of credit risk management is not the only benefits of introducing an internal rating system. The system also gives financial institutions more ideas and a 5 more solid foundation for bank management strategies, such as setting lending rates according to the borrowers’ ratings or expanding the target customer base that is the most profitable from the point of view of risk and return.
Internal ratings are a potential source of information for bank investors and regulators. For example, disclosure of the profile of a bank loans across its internal rating categories might enhance the ability of shareholders and analysts to assess bank risk. Information about the internal ratings of assets underlying asset-backed securities originated by banks, especially securitizations of traditional commercial loans, might allow investors to better appraise the risk of the securities. Some banks are reportedly already considering using internal ratings in structuring securitizations. For example, when loans in a pool are paid off, the new loans replacing them may be required to be drawn from those with a particular internal grade. External validation of internal ratings is likely to become a prerequisite for such applications because investors (or rating agencies) must understand the loss characteristics of each internal grade and have confidence that such characteristics will remain stable over time.
Currently, such validation appears quite diDcult not so much because each bank’s rating scale is different, but because loss concepts are ambiguous and the rating criteria are largely embedded in bank culture rather than written down. Moreover, as noted, most banks do not have sufficient historical data on loss experience by internal grade to support objective measurement of loss characteristics.
Credit risk rating is a summary indicator of risk for banks’ individual credit exposures and is generally assigned at the time of each underwriting or credit approval and reassessed during the credit review process. It functions as the barometer for the banks to measure their credit risk exposure to each individual customer, either in isolation or as part of their loan portfolio. The rating allows banks to measure the relevant default probabilities at different rating levels more accurately.
It helps banks to reduce their risk exposure and to improve their profitability by reducing the number of potential default loans as well as minimizing the cost associated with bad debt recovery.
Although the major objective of credit rating is to determine the ability and willingness of a borrower to pay at the agreed terms, the rating does a bit more than just classifying the borrowers into “pass” and “fail” categories.
The most important benefits for banks in using the rating system to assess their loans include:
■ Identify and decline potential risky applicants
■ Reduce losses due to defaults
■ Price the loan properly
■ Increase liquidity
■ Maximize the profit
■ Improve monitoring process
■ Reduce monitoring cost
■ Minimize administrative costs with debt collection
■ Help banks to achieve their objectives
■ Allow allocation of resources where they are more productive
■ Avoid loan concentration
The internal rating system is the prerequisite for advanced credit risk management, and each financial institution is expected to develop its own internal rating system. Every institution faces a different business environment, so each system should have its own design. There is no single answer for the framework of internal rating systems, such as the number of rating grades, a definition of each rating grade, and the method of rating assignments. Financial institutions need to introduce their own system depending on the characteristics of their loan portfolios, their operations, the objectives of the rating system, and other factors. Obviously, the institutions need to make necessary adjustments flexibly due to changes in the business environment.
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