LO 19.1: Explain the key features o f a good rating system.
Ratings play a critical role in supporting credit risk management. Ratings are also used to support credit pricing and capital provisions used to cover unanticipated credit losses. Given that defaults represent a significant source of losses for lenders, ratings are used to measure the probability of a default event occurring in a specific time horizon. Ratings are also used to support decisions made at various levels of an organization, as assessments are used to support a structured internal governance system. Ratings represent the most critical instrument used in modern and quantitative credit risk management. However, ratings must be as objective as possible meaning different credit analysts using the same inputs and methodologies should reach similar ratings.
A good rating system will possess the following three features, which together will help entities measure the appropriateness of their internal rating systems:
Objectivity and Homogeneity. An objective rating system will produce judgments based
only on considerations tied to credit risk, while a homogeneous system implies that ratings are comparable among market segments, portfolios, and customer types. Specificity. A rating system is specific if it measures the distance from a default event while ignoring other financial elements that are not directly tied to potential default. Measurability and Verifiability. Ratings must provide correct expectations related to
default probabilities which are backtested on a continuous basis.
2018 Kaplan, Inc.
Topic 19 Cross Reference to GARP Assigned Reading – De Laurentis et al., Chapter 3
E x p e r t s -B a s e d , S t a t i s t i c a l -B a s e d , a n d N u m e r i c a l A p p r o a c h e s