The International Swaps and Derivatives Association, The Risk Management Association, and the British Bankers Association discussed the results of their survey on the validation of banks' internal credit ratings at conferences in New York on June 19 and in London on June 23. (Presentation slides may be accessed by clicking the locations.)

The New Basel Capital Accord will offer banks the opportunity to use their internal credit ratings in calculating required capital. But in order to use the Internal Ratings-Based (IRB) approach, banks will have to demonstrate the capability to validate their internal ratings. In that regard, the Basel Committee included the following in its minimum requirements banks must meet before using the IRB approach:

Banks must have a robust system in place to validate the accuracy and consistency of ratings systems, processes, and the estimation of all relevant risk components. A bank must demonstrate to its supervisor that the internal validation process enables it to assess the performance of internal rating and the risk estimation systems consistently and meaningfully. (Third Consultative Paper, para. 463)

ISDA, BBA, and RMA jointly sponsored the Internal Ratings Validation project in order to assist banks in meeting these minimum requirements.

The Survey examined validation processes for specific asset classes covered in the revised Accord, including corporate exposures, specialized lending, bank exposures, retail product portfolios, and sovereigns. The 26 participating institutions completed an extensive Web-based questionnaire and many were selected for follow-up interviews. PricewaterhouseCoopers served as consultants to the project.

The Survey, which had the active support of major financial institutions and had been encouraged by leading financial regulators, does not recommend the adoption of specific methodologies or standards. Instead, the information gained through this research is intended to provide financial institutions and regulators with a better understanding of the wide range of validation techniques in use and how to implement them.

Please click here for an executive summary of the Survey. Those interested in purchasing the complete Survey results should contact Michelle Marusic at ISDA’s European office.