12 - Internal ratings, supervisory weights and collateral

Abstract

To be in control of exposure to default, a credit institution must achieve meaningful differentiation of risks within its loan books. Internal rating systems should be forward oriented providing warnings about risk drivers. In addition, internal rating systems should address all important credit risks, with both general and specific factors of exposure prescribed in detail, which may be specific to bank. This requires significant advancements in methodology and analytics as well as senior management policies adopted within Basel II guidelines. To assure objectivity and independence of the processes of assigning credit ratings as well as of monitoring the bank's rating system, the board should delegate authority and responsibility for credit rating to a unit independent of the loans operations. The implementation of a sound methodology highlights that every borrower has a rating and therefore a probability of default that is used to compute the required amount of regulatory capital. These are the basic premises put forward by Basel II and evidently impact on corporate governance and senior management responsibilities for the adequacy of internal credit rating and its use in borrower evaluation and risk management.