This section applies to institutions using a portfolio-level scaling approach to model the term structure of PIT PD. This approach is simpler to implement than transition matrices and is suitable for portfolios with smaller data sets. In this method, average PD across ratings are being modelled, instead of all transition points between ratings. This approach tends to be preferred for smaller segments. The obligor segmentation granularity is preserved at the expense of a simplification of the rating granularity.
3.7.2
In order to ensure transparency in the decision process, the modelling approach should be clearly articulated as a clear sequence of steps. It is not the object of the MMG to elaborate on the exact methodology of each step. Rather, the MMG intends to draw attention to modelling challenges and set minimum expected practices. At a minimum, the following sequence should be present in the modelling documentation:
(i)
Forecast portfolio average PIT PD per segment based on macro-PD models.
(ii)
Estimate the deviation of the portfolio PIT PD from its long term average PD.
(iii)
Apply this deviation to PDs at lower granularity levels, for instance pools or rating grades. This can be achieved by scaling in logit or probit space.
(iv)
Construct a PIT PD term structure. It is highly recommended to compare several methods and test their impacts on PD outcomes and risk metrics.
3.7.3
The drawback of this method is the generalisation of the PD volatility across grades (or pools) with the use of scalers. Certain rating grades are more prone to volatility than others, which is not reflected in this type of model. Therefore this method could result in an underestimation of the PIT PD of the lowest rating grades. Consequently, institutions should demonstrate that they assess and understand this effect.
3.7.4
Institutions should ensure that scalers lead to explainable shifts of the PD curve across rating grades and across time steps. The scalers will not be static. They will change through the forecasted time steps, since they follow the path of the PD forecasts.
3.7.5
Institutions should be aware of the theoretical and practical limitations of this approach. Its design and estimation should follow the decision process outlined in the MMS. As for any other models, institutions should assess the suitability of this methodology vs. other possible options as part of the model development process.