3.4.1
| For the purpose of risk management, the majority of institutions employ a dedicated methodology to estimate a TTC PD associated with each portfolio and, where possible, associated with each rating grade (or score) generated by their rating models. This estimation is based on the historical default rates previously computed, such that the TTC PD reflects the institution’s experience.
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3.4.2
| This process results in the construction of a PD scale, whereby the rating grades (or scores) are mapped to a single PD master scale, often common across several portfolios. This mapping exercise is referred to as ‘PD calibration’. It relies on assumptions and methodological choices separate from the rating model, therefore it is recommended to considered such mapping as a standalone model. This choice is left to each institution and should be justified. The approach should be tested, documented and validated.
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3.4.3
| Institutions should demonstrate that the granularity of segmentation employed for PD modelling is an appropriate reflection of the risk profile of their current loan book. The segmentation granularity of PD models should be based on the segmentation of rating models. In other words, the segmentation of rating models should be used as a starting point, from which segments can be grouped or split further depending on portfolio features, provided it is fully justified. This modelling choice has material consequences on the quality of PD models; therefore, it should be documented and approved by the Model Oversight Committee. Finally, the choice of PD model granularity should be formally reviewed as part of the validation process.
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3.4.4
| The rating-to-PD mapping should be understood as a relationship in either direction since no causal relationship is involved. The volatility of the grade PD through time depends on the sensitivity of the rating model and on the rating methodology employed. Such volatility will arise from a combination of migrations across rating grades and changes in the DR observed for each grade. Two situations can arise:
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| | (i)
| If rating models are sensitive to economic conditions, ratings will change and the exposures will migrate across grades, while the DR will remain stable within each grade. In this case, client ratings will change and the TTC PD assigned to each rating bucket will remain stable. |
| | (ii)
| If rating models are not sensitive to economic conditions, then the exposures will not migrate much through grades but the DR of each grade will change. In this case, client ratings will remain stable but the observed DR will deviate from the TTC PD assigned to each rating bucket.
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3.4.5
| Institutions should estimate the degree to which they are exposed to each of the situations above. Institutions are encouraged to favour the first situation, i.e. implement rating models that are sensitive to economic conditions, favour rating migrations and keep the 1-year TTC PD assigned to each rating relatively stable. For the purpose of provisioning, economic conditions should be reflected in the PIT PD in subsequent modelling. Deviation from this practice is possible but should be justified and documented.
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3.4.6
| The estimation of TTC PD relies on a set of principles that have been long established in the financial industry. At a minimum, institutions should ensure that they cover the following aspects:
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| | (i)
| The TTC PD associated with each portfolio or grade should be the long-run average estimation of the 1-year default rates for each corresponding portfolio or grade. |
| | (ii)
| The DR time series should be homogeneous and consistent through time, i.e. relate to a portfolio with similar characteristics and grading method. |
| | (iii)
| TTC PDs should incorporate an appropriate margin of conservatism depending on the time span covered and the population size. |
| | (iv)
| TTC PDs should be estimated over a minimum of five (5) years and preferably longer for wholesale portfolios. For retail portfolios, changes in product offerings should be taken into account when computing TTC PD. |
| | (v)
| The period employed for this estimation should cover at least one of the recent economic cycles in the UAE: (i) the aftermath of the 2008 financial crisis, (ii) the 2015-2016 economic slowdown after a sharp drop in oil price, and/or (iii) the Covid-19 crisis. |
| | (vi)
| If the estimation period includes too many years of economic expansion or economic downturn, the TTD PD should be adjusted accordingly.
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3.4.7
| For low default portfolios, institutions should employ a separate approach to estimate PDs. They should identify an appropriate methodology suitable to the risk profile of their portfolio. It is recommended to refer to common methods proposed by practitioners and academics to address this question. Amongst others, the Pluto & Tasche method or the Benjamin, Cathcart and Ryan method (BCR) are suitable candidates.
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3.4.8
| For portfolios that are externally rated by rating agencies, institutions can use the associated TTC PDs provided by rating agencies. However, institutions should demonstrate that (i) they do not have sufficient observed DR internally to estimate TTC PDs, (ii) each TTC PD is based on a blended estimation across the data provided by several rating agencies, (iii) the external data is regularly updated to include new publications from rating agencies, and (iv) the decision to use external ratings and PDs is reconsidered by the Model Oversight Committee on a regular basis.
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