3.3 Default Rate Estimation

3.3.1	Prior to engaging in modelling, institutions should implement a robust process to compute time series of historical default rates, for all portfolios where data is available. The results should be transparent and documented. This process should be governed and approved by the Model Oversight Committee. Once estimated, historical default rates time series should only be subject to minimal changes. Any retroactive updates should be approved by the Model Oversight Committee and by the bank’s risk management committee.
3.3.2	Institutions should estimate default rates at several levels of granularity: (i) for each portfolio, defined by obligor type or product, and (ii) for each rating grade within each portfolio, where possible. In certain circumstances, default rate estimation at rating grade level may not be possible and institutions may only rely on pool level estimation. In this case, institutions should justify their approach by demonstrating clear evidence based on data, that grade level estimation is not deemed sufficiently robust.
3.3.3	Institutions should compute the following default ratio, based on the default definition described in the previous section. This ratio should be computed with an observation window of 12 months to ensure comparability across portfolios and institutions. In addition, institutions are free estimate this ratio for other windows (e.g. quarterly) for specific modelling purposes.
	(i)	The denominator is composed of performing obligors with any credit obligation, including off and on balance sheet facilities, at the start of the observation window.
	(ii)	The numerator is composed of obligors that defaulted at least once during the observation window, on the same scope of facilities.
	Formally the default rate can be expressed as shown by the formula below, where t represented the date of estimation. Notice that if the ratio is reported at time t, then the ratio is expressed as a backward looking metrics. This concept is particularly relevant for the construction of macro models as presented in subsequent sections. The frequency of computation should be at least quarterly and possibly monthly for some portfolios.
3.3.4	When the default rate is computed by rating grade, the denominator should refer to all performing obligors assigned to a rating grade at the beginning of the observation window. When the default rate is computed at segment level, the denominator should refer to all performing obligors assigned to that segment at the beginning of the observation window.
3.3.5	For wholesale portfolios, this ratio should be computed in order to obtain quarterly observations over long time periods covering one or several economic cycles. For wholesale portfolios, institutions should aim to gather at least 5 years of data, and preferably longer. For retail portfolios or for portfolios with frequent changes in product offerings, the period covered may be shorter, but justification should be provided.
3.3.6	Institutions should ensure that default time series are homogeneous and consistent through time, i.e. relate to a portfolio with similar characteristics, consistent lending standards and consistent definition of default. Adjustments may be necessary to build time series representative of the institution current portfolios. Particular attention should be given to changes in the institution’s business model through time. This is relevant is the case of rapidly growing portfolios or, conversely, in the case of portfolio run-off strategies. This point is further explained in the MMG section focusing on macro models.
3.3.7	If an obligor migrates between ratings or between segments during the observation period, the obligor should be included in the original rating bucket and/or original segment for the purpose of estimating a default rate. Institutions should document any changes in portfolio segmentation that occurred during the period of observation.
3.3.8	When the default rate is computed by rating grade, the ratings at the beginning of the observation window should not reflect risk transfers or any form of parent guaranties, in order to capture the default rates pertaining to the original creditworthiness of the obligors. The ratings at the start of the observation window can reflect rating overrides if these overrides relate to the obligors themselves, independently of guarantees.
3.3.9	When default rate series are computed over long time periods, it could happen that obligors come out of their default status after a recovery and a cure period. In subsequent observation windows, such obligors could be performing again and default again, in which case another default event should be recorded. For that purpose, institutions should define minimum cure periods per product and/or portfolio type. If a second default occurs after the end of the cure period, it should be recorded as an addition default event. These cure periods should be based on patterns observed in data sets.
3.3.10	Provided that institutions follow the above practices, the following aspects remain subject to the discretion of each institution. First, they may choose to exclude obligors with only undrawn facilities from the numerator and denominator to avoid lowering unduly the default rate of obligors with drawn credit lines. Second, institutions may also choose to estimate default rates based on exposures rather than on counts of obligors; such estimation provides additional statistical information on expected exposures at default.