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

Abstract

Although much research has been devoted to external credit ratings, relatively little is known about the workings of banks' internal ratings. This paper aims at improving our understanding of internal risk rating systems (IRS) at large banks and the way in which they are implemented, and at verifying if IRS produce consistent estimates of banks' loan portfolio credit risk. An important property of our work is that we derive our measures of credit risk without making any assumptions about correlations between loans, due to the fact that the size of the data allows us to apply Carey's [16] non-parametric Monte Carlo re-sampling method. We find substantial differences between the implied loss distributions of the two banks with equal regulatory risk profiles; both expected losses and the credit loss rates at a wide range of loss distribution percentiles vary considerably. Such variation will most likely translate into different levels of required economic capital. Our results also confirm the quantitative importance of size for portfolio credit risk: for common parameter values, we find that tail risk can be reduced by up to 40 percent by doubling portfolio size. Our analysis makes clear that not only the formal design of a rating system, but also the way in which it is implemented (e.g. a portfolio's rating grade composition; the degree of homogeneity within rating classes) can be quantitatively important for the shape of credit loss distributions and thus for banks' required capital structure. The evidence of differences between lenders also hints at the presence of differentiated market equilibria, that are more complex than might otherwise be supposed: different lending or risk management styles may emerge and banks strike their own balance between risk-taking and (the cost of) monitoring (that risk).

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

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