Rating models generally produce an ordinal indicator on a predefined scale representing creditworthiness. The scores produced by each models should be mapped to a fixed internal rating scale employed across all aspects of credit risk management, in particular for portfolio management, provision estimation and capital assessment. The rating scale should be the result of explicit choices that should be made as part of the model governance framework outlined in the MMS. At a minimum, the institution’s master rating scale should comply with the below principles:
(i)
The granularity of the scale should be carefully defined in order to support credit risk management appropriately. An appropriate balance should be found regarding the number of grades. A number of buckets that is too small will reduce the accuracy of decision making. A number of buckets that is too large will provide a false sense of accuracy and could be difficult to use for modelling.
(ii)
Institutions should ensure that the distribution of obligors (or exposures) spans across most rating buckets. High concentration in specific grades should be avoided, or conversely the usage of too many grades with no obligors should also be avoided. Consequently, institution may need to redefine their rating grades differently from rating agencies’ grades, by expanding or grouping certain grades.
(iii)
The number of buckets should be chosen in such a way that the obligors’ probability of default in each grade can be robustly estimated (as per the next section on PD models).
(iv)
The rating scale from external rating agencies may be used as a benchmark, however their granularity may not be the most appropriate for a given institution. Institutions with a large proportion of their portfolio in non-investment grade rating buckets should pay particular attention to bucketing choices. They are likely to require more granular buckets in this portion of the scale to assess their risk more precisely than with standard scales from rating agencies.
(v)
The choice of an institution’s rating scale should be substantiated and documented. The suitability of rating scale should be assessed on a regular basis as part of model validation.