Banks asked to implement internal credit risk rating system

KARACHI: The State Bank of Pakistan (SBPP) on Wednesday directed all banks to ensure sound implementation of internal credit risk rating system for their retail loans with a view to mitigate the risk of being default on such portfolios, according to a statement.

The two dimensional rating requirement is applicable on corporate, commercial and the SME portfolios; however, banks and development finance institutions (DFIs) may follow a single dimension internal credit risk rating system for their retail loans but with leaning both borrower and transaction risk and capture all the relevant borrowers and transaction characteristics, it said.

According to a circular issued by the State Bank, banks would develop an application and behavioral scorecards. Application scorecards measure the credit worthiness of a customer specifically at the application stage, based on the application or credit initiation data, it said. Whereas, behavioral scorecards measure the credit risk of a customer by monitoring the repayment behavior, changes in demographics and customers’ compliance with the loan covenants, etc.

These are more particularly used in credit management and monitoring decisions such as credit renewal or restriction, limit enhancement / reduction, re-pricing, provisioning, etc. The banks should review and update the assigned scores at regular intervals, which may range from one month to a maximum of one year, according to the circular.

The circular also said that the selection of default drivers to be used for the scorecard development depends on power of these drivers towards predicting the default and, as such, these may vary from one portfolio to another.

The selection of an appropriate model is at the banks’ discretion, it said, adding that a list of some of the default drivers that may be used for application and behavioral scorecards is annexed. However, these are suggestive default drivers and banks would incorporate as many default drivers as they deem fit for their portfolio.

“The banks should validate the predictive power of the default drivers and the model before putting the scorecard in use. Moreover, the predicted and actual defaults should be monitored on an ongoing basis and in the case of significant deviation, scorecard should be validated,” it said.

“The banks should validate the scorecard on an annual basis,” it added.

According to the circular, the banks need to analyse every retail loan using a set of default drivers and assign a specific score to each loan. Moreover, for advance approaches of the credit risk under Basel II, the rating of retail portfolio is done on pooled basis. As such, the banks would assign each exposure that falls within the definition of retail for IRB purposes into a particular pool.

“Banks may use various attributes of the default drivers used in the application and behavioral scorecards, as well as ranges of the assigned scores for segregating the portfolio into different pools,” it said.

The banks must demonstrate that this process provides for a meaningful differentiation of risk, provides for a grouping of sufficiently homogenous exposures, and allows for accurate and consistent estimation of loss characteristics at the pool level, it said. Each obligor should be assigned a pool on the basis of its risk profile such that exposures sharing similar risk attributes should be assigned the same pool.

There must be a meaningful distribution of borrowers and exposures across pools and a single pool must not include an undue concentration of the banks’ total retail exposure.

While reporting in e-CIB, the banks are required to comply with the following points: Application scores can generally be used up to six months after underwriting the loan and after that, the banks would use behavioral scores.

The banks need to map the assigned scores to one of the 12 rating grades defined in BSD Circular No. 08 of 2007.

The rating corresponding to the highest risk (lowest rating) should be reported in the e-CIB in case the obligor has been assigned multiple ratings based on multiple exposures, it added.

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