EBA · 2015_1859 Final Q&A

When should an external rating be considered as a primary factor determining an internal rating assignment

Regulation
Regulation (EU) No 575/2013 (CRR)
Article
143, para. 5
Topic
Credit risk
Submitted by
Consultancy firm
Submitted
2015-03-01
Answered
2015-06-19
Answer provided by
ESAs (EBA, ESMA, EIOPA)

Question

Concerning the practical application of the RTS on materiality: When should an external rating be considered as a 'primary factor' determining an internal rating assignment, and by what measure is the relative importance of the different variables comprising an internal model for credit risk to be evaluated?

Background

According to Annex I, part 2, section 1, paragraph 2(e) in the abovementioned RTS, the introduction or withdrawal of an external rating as a primary factor determining an internal rating assignment should be considered as a change requiring competent authorities' approval (i.e. ‘material’). However, it is not specified what is meant by 'primary factor' in this context. Neither is it explained how the relative importance of the different variables included in an internal model for credit risk is to be evaluated. For example, when an external rating is included as one of the risk drivers in a statistical scoring model, it is usually found to be a 'strong' variable (this can be evaluated by several different means, such as information value ordering or by comparing the Wald Chi-2 test statistics). Obviously, if the external rating turns out to be a very dominating variable (say > 90% of the total weight in the model) it should be considered primary. And if it turns out to be the least important variable it should perhaps not be considered primary. But what if the external rating is found to be the second or third most important variable in the model?

Answer

The EBA does not aim to decide on quantitative criteria to determine when an external rating is considered as 'primary factor' in determining an internal rating assignment. Given the variety of models used to combine the numerous factors used to determine the assignment to grade or pool (e.g. weighted sums, scoring models etc.) and the large variety of potential metrics for assessing the relevance of different factors, institutions should assess themselves if, in their algorithms and procedures for internal rating assignment, the external ratings should be considered a primary factor. This assessment by institutions must be well-explained and justified in order that an external rating can be considered as not 'primary'. Further, pursuant to Title 1, Article 3(4) of the Commission Delegated Regulation (EU) No 529/2014 on assessing the materiality of extensions and changes of the IRB and AMA approaches, in case of doubt, institutions shall assign extensions and changes to the category of the highest potential materiality, and so in this case, shall assign external ratings as 'primary'.

Original source: European Banking Authority, Q&A ID 2015_1859

This Q&A is published by European Banking Authority and is non-binding. It does not constitute legal advice. Updated weekly from official ESA sources.

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