Internal Ratings Systems, Implied Credit Risk and the Consistency of Banks' Risk Classification Policies

33 Pages Posted: 30 Aug 2005

See all articles by Tor Jacobson

Tor Jacobson

Sveriges Riksbank - Research Division

Jesper Lindé

Sveriges Riksbank - Research Division

Kasper Roszbach

Norges Bank - Research Department; University of Groningen - Faculty of Economics and Business

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Abstract

Counterpart risk rating is at the heart of the banking business. In the new Basel II regulation, internal ratings have been given a central role. Although much research has been done on external ratings, much less is known about banks' internal ratings. This paper presents new quantitative evidence on the consistency of internal ratings based on panel data from the complete business loan portfolios of two Swedish banks and a credit bureau over the period 1997-2000. We study rating class distributions, transitions and default behavior and compute the credit loss distributions that each rating system implies by means of a semi-parametric Monte Carlo re-sampling method following Carey (1998). Our results reveal, for a portfolio with identical counterparts, substantial differences in the implied riskiness between banks. Such differences could translate into different amounts of required economic capital and create (new) incentives to securitize part of their loan portfolios or increase the riskiness of loans in certain rating classes. We also shed light on the quantitative importance of portfolio composition, portfolio size and the forecast horizon for loss distributions. For example, with common portfolio parameters, credit risk can be reduced by up to 40 percent by doubling the loan portfolio size. We also discuss the relation between loss distributions and the desirable level of insolvency risk.

Keywords: Internal ratings, credit risk, tails, Value-at-Risk, banks, Basel II

JEL Classification: C14, C15, G21, G28, G33

Suggested Citation

Jacobson, Tor and Linde, Jesper and Roszbach, Kasper F., Internal Ratings Systems, Implied Credit Risk and the Consistency of Banks' Risk Classification Policies. Journal of Banking and Finance, Forthcoming, Riksbank Working Paper No. 155, Available at SSRN: https://ssrn.com/abstract=792825

Tor Jacobson

Sveriges Riksbank - Research Division ( email )

S-103 37 Stockholm
Sweden
+46 8 787 0000 (Phone)

HOME PAGE: www.riksbank.com

Jesper Linde

Sveriges Riksbank - Research Division ( email )

S-103 37 Stockholm
Sweden
+46 8 787 0873 (Phone)

HOME PAGE: http://www.riksbank.com

Kasper F. Roszbach (Contact Author)

Norges Bank - Research Department ( email )

P.O. Box 1179
Oslo, N-0107
Norway

University of Groningen - Faculty of Economics and Business ( email )

Department of Economics, Econometrics and Finance
Nettelbosje 2
Groningen, NL 9747 AE
Netherlands

HOME PAGE: http://www.rug.nl/staff/k.f.roszbach/

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