Changing Rating Models – What to consider
When changing a rating system, there are so many attributes and downstream impact you have to think about and plan way ahead. Change of a rating system could be a complete move from one vendor to another, it could also be a revision upgrade or changes in factors or regulator driven directive that impacts how you calculate risk ratings.
When you purchase a rating model or develop your own, go through the documentation with a fine toothcomb, understand the triggers, the various factors that have a major or minor effect on the rating outcome, look at the PDs.
Rating Logic Comparison
Part of any model validation process is to do a comparison exercise between your current and proposed rating model. Understand some key weighting bias, as some models give non-quantitative inputs more of an important factor which in turn would require greater discipline when these inputs are created by the sales channel. Some policies and procedures may need to be adjusted to cater for your new model strategy, both for the sales channel or the credit risk teams.
Do not try to replicate or formally create parallels with your existing rating results, your new rating models no doubt have similarities but are quite different mechanically, and some are “black-boxes” which you cannot analyse.
If you cannot run the models in parallel side-by-side on the whole portfolio, then the smallest sample you should consider is 30% of the overall portfolio, and make sure you have a cross section of company sizes (turnover or number of employees), different sectors and industries, to ensure your sample is representative of your customer base.
Then take the previous PD matrix and compare it with the new PD matrix for the same or equivalent rating grades. This should show you any outline of differences, common clusters and any spreads, which will give you a better idea how this will impact your downstream activities.
Downstream Consideration & Impact
There are many downstream systems that would be affected, so plan ahead and ensure you have covered all the basis. For instance, check if your core banking system has any special triggers that automatically move accounts into non-performing groups based on a rating grade, or starts to provision if a rating grade is breached. Your regulatory reporting teams have to be advised, as they many have their own reporting and events that depend on rating results. Once you have done your due diligence and portfolio analysis on a sample set or your whole portfolio, you may want to alert the regulator prior to filing, indicating you have changed your rating model, the reasons why you have done so, and indicate any major shifts in your portfolio due to this new system.
There are other areas which are affected significantly, so before you publish your findings, see how the new rating platform affects IBNR, RAROC, Credit Valuation Adjustment (CVA) capital many other disclosures that your organization requires to publish that have a rating grade dependency.