ABSTRACT
The structure of Basel II rests on the ‘Three Pillars’ so called by the Committee, namely: Pillar 1 Minimum capital requirements Pillar 2 Supervisory review process Pillar 3 Market discipline. Only the first pillar will concern us here since it contains the rules governing the credit rating of bank customers which is the central topic of this book. Approaches to rating your risk The central instrument by which Basel II aims to realise its concept of risk-sensitive asset weighting is credit rating. Credit risk is the risk of borrowers failing to pay interest and repay principal on the dates agreed. More specifically, and in terms of Basel II, credit risk is the borrower’s ‘Probability of Default’ (PD), where default is defined as follows:
A default is considered to have occurred with regard to a particular obligor when either or both of the two following events have taken place. • The bank considers that the obligor is unlikely to pay its credit obligations to the
banking group in full … • The obligor is past due more than 90 days on any material credit obligation to the
banking group … (452) Its definition as probability gives risk an objective, that is, statistically quantifiable, dimension. The quantification enables the derivation of risk weights by which to adjust the assets that enter the calculation of a bank’s minimum capital requirement. The traditional practice of credit rating is to assign borrowers or assets to risk categories conveniently calibrated for the practical purposes of risk evaluation and risk management. Throughout the text of the accord Basel II makes abundantly clear that by its use of the terms credit assessment or credit rating it implies professional standards compatible with those of established rating institutions. The Committee initiated a study of professional rating practice published in a working paper entitled Credit Ratings and Complementary Sources of Credit Quality Information in August 2000.
