Directive 2006/48/EC of the European Parliament and of the council of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions (recast) (Text with EEA relevance) (repealed) (c. 48)

ANNEX VII U.K. INTERNAL RATINGS BASED APPROACH

PART 4 U.K. Minimum requirements for IRB Approach

1. RATING SYSTEMS U.K.

1. A ‘rating system’ shall comprise all of the methods, processes, controls, data collection and IT systems that support the assessment of credit risk, the assignment of exposures to grades or pools (rating), and the quantification of default and loss estimates for a certain type of exposure. U.K.

2. If a credit institution uses multiple rating systems, the rationale for assigning an obligor or a transaction to a rating system shall be documented and applied in a manner that appropriately reflects the level of risk. U.K.

3. Assignment criteria and processes shall be periodically reviewed to determine whether they remain appropriate for the current portfolio and external conditions. U.K.

1.1. Structure of rating systems U.K.

4. Where a credit institution uses direct estimates of risk parameters these may be seen as the outputs of grades on a continuous rating scale. U.K.

1.1.1. Exposures to corporates, institutions and central governments and central banks U.K.

5. A rating system shall take into account obligor and transaction risk characteristics. U.K.

6. A rating system shall have an obligor rating scale which reflects exclusively quantification of the risk of obligor default. The obligor rating scale shall have a minimum of 7 grades for non-defaulted obligors and one for defaulted obligors. U.K.

7. An ‘obligor grade’ shall mean a risk category within a rating system's obligor rating scale, to which obligors are assigned on the basis of a specified and distinct set of rating criteria, from which estimates of PD are derived. A credit institution shall document the relationship between obligor grades in terms of the level of default risk each grade implies and the criteria used to distinguish that level of default risk. U.K.

8. Credit institutions with portfolios concentrated in a particular market segment and range of default risk shall have enough obligor grades within that range to avoid undue concentrations of obligors in a particular grade. Significant concentrations within a single grade shall be supported by convincing empirical evidence that the obligor grade covers a reasonably narrow PD band and that the default risk posed by all obligors in the grade falls within that band. U.K.

9. To qualify for recognition by the competent authorities of the use for capital requirement calculation of own estimates of LGDs, a rating system shall incorporate a distinct facility rating scale which exclusively reflects LGDrelated transaction characteristics. U.K.

10. A ‘facility grade’ shall mean a risk category within a rating system's facility scale, to which exposures are assigned on the basis of a specified and distinct set of rating criteria from which own estimates of LGDs are derived. The grade definition shall include both a description of how exposures are assigned to the grade and of the criteria used to distinguish the level of risk across grades. U.K.

11. Significant concentrations within a single facility grade shall be supported by convincing empirical evidence that the facility grade covers a reasonably narrow LGD band, respectively, and that the risk posed by all exposures in the grade falls within that band. U.K.

12. Credit institutions using the methods set out in Part 1, point 6 for assigning risk weights for specialised lending exposures are exempt from the requirement to have an obligor rating scale which reflects exclusively quantification of the risk of obligor default for these exposures. Notwithstanding point 6, these institutions shall have for these exposures at least 4 grades for non-defaulted obligors and at least one grade for defaulted obligors. U.K.

1.1.2. Retail exposures U.K.

13. Rating systems shall reflect both obligor and transaction risk, and shall capture all relevant obligor and transaction characteristics. U.K.

14. The level of risk differentiation shall ensure that the number of exposures in a given grade or pool is sufficient to allow for meaningful quantification and validation of the loss characteristics at the grade or pool level. The distribution of exposures and obligors across grades or pools shall be such as to avoid excessive concentrations. U.K.

15. Credit institutions shall demonstrate that the process of assigning exposures to grades or pools provides for a meaningful differentiation of risk, provides for a grouping of sufficiently homogenous exposures, and allows for accurate and consistent estimation of loss characteristics at grade or pool level. For purchased receivables the grouping shall reflect the seller's underwriting practices and the heterogeneity of its customers. U.K.

16. Credit institutions shall consider the following risk drivers when assigning exposures to grades or pools. U.K.

(a)

Obligor risk characteristics;

(b)

Transaction risk characteristics, including product or collateral types or both. Credit institutions shall explicitly address cases where several exposures benefit from the same collateral; and

(c)

Delinquency, unless the credit institution demonstrates to its competent authority that delinquency is not a material risk drivers for the exposure;

1.2. Assignment to grades or pools U.K.

17. A credit institution shall have specific definitions, processes and criteria for assigning exposures to grades or pools within a rating system. U.K.

(a)

The grade or pool definitions and criteria shall be sufficiently detailed to allow those charged with assigning ratings to consistently assign obligors or facilities posing similar risk to the same grade or pool. This consistency shall exist across lines of business, departments and geographic locations;

(b)

The documentation of the rating process shall allow third parties to understand the assignments of exposures to grades or pools, to replicate grade and pool assignments and to evaluate the appropriateness of the assignments to a grade or a pool; and

(c)

The criteria shall also be consistent with the credit institution's internal lending standards and its policies for handling troubled obligors and facilities.

18. A credit institution shall take all relevant information into account in assigning obligors and facilities to grades or pools. Information shall be current and shall enable the credit institution to forecast the future performance of the exposure. The less information a credit institution has, the more conservative shall be its assignments of exposures to obligor and facility grades or pools. If a credit institution uses an external rating as a primary factor determining an internal rating assignment, the credit institution shall ensure that it considers other relevant information. U.K.

1.3. Assignment of exposures U.K.

1.3.1. Exposures to corporates, institutions and central governments and central banks U.K.

19. Each obligor shall be assigned to an obligor grade as Part of the credit approval process. U.K.

20. For those credit institutions permitted to use own estimates of LGDs and/or conversion factors, each exposure shall also be assigned to a facility grade as Part of the credit approval process. U.K.

21. Credit institutions using the methods set out in Part 1, point 6 for assigning risk weights for specialised lending exposures shall assign each of these exposures to a grade in accordance with point 12. U.K.

22. Each separate legal entity to which the credit institution is exposed shall be separately rated. A credit institution shall demonstrate to its competent authority that it has acceptable policies regarding the treatment of individual obligor clients and groups of connected clients. U.K.

23. Separate exposures to the same obligor shall be assigned to the same obligor grade, irrespective of any differences in the nature of each specific transaction. Exceptions, where separate exposures are allowed to result in multiple grades for the same obligor are: U.K.

(a)

country transfer risk, this being dependent on whether the exposures are denominated in local or foreign currency;

(b)

where the treatment of associated guarantees to an exposure may be reflected in an adjusted assignment to an obligor grade; and

(c)

where consumer protection, bank secrecy or other legislation prohibit the exchange of client data.

1.3.2. Retail exposures U.K.

24. Each exposure shall be assigned to a grade or a pool as part of the credit approval process. U.K.

1.3.3. Overrides U.K.

25. For grade and pool assignments credit institutions shall document the situations in which human judgement may override the inputs or outputs of the assignment process and the personnel responsible for approving these overrides. Credit institutions shall document these overrides and the personnel responsible. Credit institutions shall analyse the performance of the exposures whose assignments have been overridden. This analysis shall include assessment of the performance of exposures whose rating has been overridden by a particular person, accounting for all the responsible personnel. U.K.

1.4. Integrity of assignment process U.K.

1.4.1. Exposures to corporates, institutions and central governments and central banks U.K.

26. Assignments and periodic reviews of assignments shall be completed or approved by an independent party that does not directly benefit from decisions to extend the credit. U.K.

27. Credit institutions shall update assignments at least annually. High risk obligors and problem exposures shall be subject to more frequent review. Credit institutions shall undertake a new assignment if material information on the obligor or exposure becomes available. U.K.

28. A credit institution shall have an effective process to obtain and update relevant information on obligor characteristics that affect PDs, and on transaction characteristics that affect LGDs and/or conversion factors. U.K.

1.4.2. Retail exposures U.K.

29. A credit institution shall at least annually update obligor and facility assignments or review the loss characteristics and delinquency status of each identified risk pool, whichever applicable. A credit institution shall also at least annually review in a representative sample the status of individual exposures within each pool as a means of ensuring that exposures continue to be assigned to the correct pool. U.K.

1.5. Use of models U.K.

30. If a credit institution uses statistical models and other mechanical methods to assign exposures to obligors or facilities grades or pools, then: U.K.

(a)

the credit institution shall demonstrate to its competent authority that the model has good predictive power and that capital requirements are not distorted as a result of its use. The input variables shall form a reasonable and effective basis for the resulting predictions. The model shall not have material biases;

(b)

the credit institution shall have in place a process for vetting data inputs into the model, which includes an assessment of the accuracy, completeness and appropriateness of the data;

(c)

the credit institution shall demonstrate that the data used to build the model is representative of the population of the credit institution's actual obligors or exposures;

(d)

the credit institution shall have a regular cycle of model validation that includes monitoring of model performance and stability; review of model specification; and testing of model outputs against outcomes; and

(e)

the credit institution shall complement the statistical model by human judgement and human oversight to review model-based assignments and to ensure that the models are used appropriately. Review procedures shall aim at finding and limiting errors associated with model weaknesses. Human judgements shall take into account all relevant information not considered by the model. The credit institution shall document how human judgement and model results are to be combined.

1.6. Documentation of rating systems U.K.

31. The credit institutions shall document the design and operational details of its rating systems. The documentation shall evidence compliance with the minimum requirements in this part, and address topics including portfolio differentiation, rating criteria, responsibilities of parties that rate obligors and exposures, frequency of assignment reviews, and management oversight of the rating process. U.K.

32. The credit institution shall document the rationale for and analysis supporting its choice of rating criteria. A credit institution shall document all major changes in the risk rating process, and such documentation shall support identification of changes made to the risk rating process subsequent to the last review by the competent authorities. The organisation of rating assignment including the rating assignment process and the internal control structure shall also be documented. U.K.

33. The credit institutions shall document the specific definitions of default and loss used internally and demonstrate consistency with the definitions set out in this Directive. U.K.

34. If the credit institution employs statistical models in the rating process, the credit institution shall document their methodologies. This material shall: U.K.

(a)

provide a detailed outline of the theory, assumptions and/or mathematical and empirical basis of the assignment of estimates to grades, individual obligors, exposures, or pools, and the data source(s) used to estimate the model;

(b)

establish a rigorous statistical process (including out-of-time and out-of-sample performance tests) for validating the model; and

(c)

indicate any circumstances under which the model does not work effectively.

35. Use of a model obtained from a third-party vendor that claims proprietary technology is not a justification for exemption from documentation or any other of the requirements for rating systems. The burden is on the credit institution to satisfy competent authorities. U.K.

1.7. Data maintenance U.K.

36. Credit institutions shall collect and store data on aspects of their internal ratings as required under Articles 145 to 149. U.K.

1.7.1. Exposures to corporates, institutions and central governments and central banks U.K.

37. Credit institutions shall collect and store: U.K.

(a)

complete rating histories on obligors and recognised guarantors;

(b)

the dates the ratings were assigned;

(c)

the key data and methodology used to derive the rating;

(d)

the person responsible for the rating assignment;

(e)

the identity of obligors and exposures that defaulted;

(f)

the date and circumstances of such defaults; and

(g)

data on the PDs and realised default rates associated with rating grades and ratings migration;

Credit institutions not using own estimates of LGDs and/or conversion factors shall collect and store data on comparisons of realised LGDs to the values as set out in Part 2, point 8 and realised conversion factors to the values as set out in Part 3, point 9.

38. Credit institutions using own estimates of LGDs and/or conversion factors shall collect and store: U.K.

(a)

complete histories of data on the facility ratings and LGD and conversion factor estimates associated with each rating scale;

(b)

the dates the ratings were assigned and the estimates were done;

(c)

the key data and methodology used to derive the facility ratings and LGD and conversion factor estimates;

(d)

the person who assigned the facility rating and the person who provided LGD and conversion factor estimates;

(e)

data on the estimated and realised LGDs and conversion factors associated with each defaulted exposure;

(f)

data on the LGD of the exposure before and after evaluation of the effects of a guarantee/or credit derivative, for those credit institutions that reflect the credit risk mitigating effects of guarantees or credit derivatives through LGD; and

(g)

data on the components of loss for each defaulted exposure.

1.7.2. Retail exposures U.K.

39. Credit institutions shall collect and store: U.K.

(a)

data used in the process of allocating exposures to grades or pools;

(b)

data on the estimated PDs, LGDs and conversion factors associated with grades or pools of exposures;

(c)

the identity of obligors and exposures that defaulted;

(d)

for defaulted exposures, data on the grades or pools to which the exposure was assigned over the year prior to default and the realised outcomes on LGD and conversion factor; and

(e)

data on loss rates for qualifying revolving retail exposures.

1.8. Stress tests used in assessment of capital adequacy U.K.

40. A credit institution shall have in place sound stress testing processes for use in the assessment of its capital adequacy. Stress testing shall involve identifying possible events or future changes in economic conditions that could have unfavourable effects on a credit institution's credit exposures and assessment of the credit institution's ability to withstand such changes. U.K.

41. A credit institution shall regularly perform a credit risk stress test to assess the effect of certain specific conditions on its total capital requirements for credit risk. The test shall be one chosen by the credit institution, subject to supervisory review. The test to be employed shall be meaningful and reasonably conservative, considering at least the effect of mild recession scenarios. A credit institution shall assess migration in its ratings under the stress test scenarios. Stressed portfolios shall contain the vast majority of a credit institution's total exposure. U.K.

42. Credit institutions using the treatment set out in Part 1, point 4 shall consider as Part of their stress testing framework the impact of a deterioration in the credit quality of protection providers, in particular the impact of protection providers falling outside the eligibility criteria. U.K.