24.11.04
 
A Draft of the Guidelines Addressing Credit Rating Systems in Banks Toward the Implementation of the 'Basel II' Principles in Israel
 
The Supervisor of Banks, Mr. Yoav Lehman, promulgated the first draft of guidelines for internal credit rating systems of corporates, banks and sovereigns that was crafted by the Banking Supervision Department (BSD). This draft is the onset of a series of supervisory measures designed to eventually apply the Basel II principles in Israel.
The BSD explicates that the principles set out in Basel II, which were formulated in a protracted international process by the Basel Committee, are fore mostly fashioned to upscale the level of risk management in the global banking system, including the management of capital adequacy. The BSD in Israel views the upgrading of the banks risk management as a supervisory priority that is paramount. These principles will form an intricate, comprehensive and precise alignment between capital adequacy and the risks associated to the banks' exposures. In the area of credit, this type of measurement needs to be performed by employing advanced rating systems, whose guidelines are specified in this circulated draft.
     
Basel II principles introduces two approaches for the capital charge against credit risk exposures - The Standardized Approach which is based primarily on the borrowers' external credit ratings and the Advanced Internal Model Approach that incorporates the banks' advanced credit rating system. BSD in Israel envisages to promote an internal rating system devised by the banks, which is instrumental in improving their credit risk management and is part of a future trend to implement the advanced internal model approaches by the larger banking groups in Israel for the purpose of calculating their capital adequacy under the Basel II regime.
     
The draft circulated to the banks sets out the minimum standards for the rating systems construction, operation, estimation of risk components and the performing of validation process of the systems and estimates. The control and oversight mechanisms scrutinizing the rating systems were highlighted, and in particular, allude to the involvement of the management and board of directors and their responsibilities for the viability of the rating systems and the integrity of the rating model.
The BSD intends to embark on consultations with the banks concerning this draft. The consultations will be held in a conjunctive professional forum and also with banks separately, in order to promote the final design of the regulations and to upgrade the required infrastructure. The full implementation of advanced rating systems in Israel is anticipated within the next few years.
     
The following main topics are addressed in this draft:
1. The minimum standards for a rating system comprise of:
    A rating system that should be "two dimensional" by meaningfully distinguishing between the different exposures of the two dimensions - the risk (probability) of default of the borrower (PD - Probability of Default) and the severity of the loss given default (LGD - Loss Given Default). Minimum standards were specified in regard to the method employed for the quantification of these risk components. The grades that will be assigned to the risk ranking scale will reflect a quantitative estimate of the probability of default rates and the loss given default rates accordingly.
    The establishment of an ongoing process for the validation of the rating systems. This retrospective process must demonstrate that the quantitative estimates of the risk components are accurate and consistent.
    A certain degree of leeway has been granted to the banks in determining the appropriate rating methods and in respect to the rating philosophy, quantification methodologies, the number of grades in each scale, etc.
2. The definition of default was specified, ensuring a consistent and uniform identification of default events across all banks, which constitutes one of the essential and basic foundations of a rating system.
3. The minimum operational standards have been set for rating systems. These include the scope (sorting out the borrowers that will be rated), updating, rating independence, internal use of ratings, documentation, database and its applications.
4. The minimum standards for the validation process of the rating systems and the quantitative estimates are specified.
5. The emphasis on corporate governance is accentuated in respect to the involvement of the management and board of directors and their responsibilities for the adequacy of the rating systems and the integrity of the rating model. The board of directors are expected to layout the overall policies for adopting the required standards as part of the groundwork for their implementation. The board of directors and management must ensure the existence of a predetermined action plan that facilitates implementation, defines a timetable and execution priorities and verifies coordination among the different functions and systems in the bank. In addition, the board of directors and management must structure, among other things, appropriate incentive and retributive mechanisms, and nurture an organizational culture that is uncompromising towards the adequacy of the ratings and that is intolerant of errors and deviations.
6. The minimum standards concerning the control and oversight mechanisms are specified: independence, transparency, professional accountability, rating employment, control, auditing and the responsibilities of the management and board of directors.
  Adherence to the standards pertaining to the independence of the ratings will compel, in most cases, reconsideration of the organizational structure relating to management, oversight and controls of credit risk. The essential functions and minimum segregation required between them are specified. The design of the appropriate organizational structure that accommodates the banks needs is left to the discretion of each bank, on condition that the bank abides by the minimum standards set on this issue.
7. The use of internal ratings of borrowers and credit must be central in the credit risk management of the bank, in the oversight and internal control of this risk, and eventually in the allocation of capital according to the banks risks. The use of the internal ratings for managerial purposes, in itself, constitutes an additional control element of the rating system.
8. A computerized, qualitative and broad database is a crucial prerequisite for the construction and employment of these rating systems. The applied usages of this data and some examples of data collection are specified:
    Each bank has to assume the duty of undertaking prompt action to ensure an ongoing collection of the data that it defined as crucial. However, due to the fact that default event data is generally "data in dearth" and in light of the multiple incidents of these events in Israel in recent years, the banks must collect data at least from 1.1.01, including the defaulted borrowers' characteristics and the ensuing loss data. In addition, they will have to collect data on other borrowers that will augment the construction of the rating systems and the outputting of estimates.
    The banks must give thought to the potential challenges arising from data integration and to the plausible scenario that ongoing capabilities of integration may engender a significant enhancement of the computer systems.
    The rating systems should be sustained by a wide range of data in order to reinforce the validity of the estimation. Consequently, and due to a relatively small Israeli economy, it is recommended for banks to consider collaboration in regard to the data and to the construction of databases without jeopardizing banking secrecy (in other words by omitting the borrowers particulars). Accordingly, banks can pursue data collaboration with other countries if those databases contain the relevant characteristics.