1 BIPRU 4 applies to a firm with an IRB permission.

A firm must calculate its credit risk capital component as the sum of:

1. (1)

   (for exposures to which the standardised approach is applied) the credit risk capital component as calculated under BIPRU 3.1.5 R; and

2. (2)

   (for exposures to which the IRB approach is applied to which the standardised approach would otherwise apply in accordance with BIPRU 3.1.5 R (Credit risk capital component)), 8% of the total of the firm'srisk weighted exposure amounts calculated in accordance with the IRB approach.

A reference in the Handbook to a provision of the IRB approach, in the case of a firm:

1. (1)

   excludes any provision of the IRB approach set out in the Handbook that is not applied to that firm by its IRB permission;

2. (2)

   includes any additional provision contained in the firm'sIRB permission; and

3. (3)

   takes into account any other amendments made to the provisions in the Handbook relating to the IRB approach made by the firm'sIRB permission.

To the extent that a firm'sIRB permission does not allow it to use a particular approach in the Handbook relating to the IRB approach the Handbook provision in question does not apply to the firm.

If a provision of the Handbook relating to the IRB approach says that a firm may do something if its IRB permission allows it, a firm may do that thing unless its IRB permission expressly says that it may not do so except that:

1. (1)

   BIPRU 4.2.18 R - BIPRU 4.2.19 R (Sequential implementation of IRB approach) and BIPRU 4.2.26 R (1)-BIPRU 4.2.26R (5) (Combined use of standardised approach with IRB approach) only apply if expressly permitted by a firm'sIRB permission;

2. (2)

   a firm may not use the advanced IRB approach for the sovereign, institution and corporate IRB exposure class except to the extent expressly permitted by the firm'sIRB permission;

3. (3)

   if a firm uses its own estimates of LGD and conversion factors it may only take into account unfunded credit protection to reduce LGD in the manner set out in its IRB permission;

4. (4)

   if a firm uses its own estimates of LGD and conversion factors it may only recognise the effects of financial collateral under BIPRU 10.6.17 R (Exemptions for firms using own estimates of LGD and conversion factors under the IRB approach)4 in the manner set out in its IRB permission;

5. (5)

   a firm must deal with equity exposures in the manner set out in its IRB permission; and

6. (6)

   (in the case of collateral that is only eligible for recognition under paragraph 21 of Part 1 of Annex VIII of the Banking Consolidation Directive (Other physical collateral)) a firm may not recognise as eligible collateral an item of a type referred to in BIPRU 4.10.16 R (Other physical collateral) unless that item is of a type specified as permitted in its IRB permission.

If a firm ceases to comply with the requirements of the IRB approach, it must either present to the FSA a plan for a timely return to compliance or demonstrate that the effect of non-compliance is immaterial.

[Note: BCD Article 84(5)]

This section applies to all exposures treated under the IRB approach.

A firm's systems for the management and rating of credit risk exposures must be sound and implemented with integrity and, in particular, they must meet the following standards in accordance with the minimum IRB standards:

1. (1)

   the firm'srating systems provide for a meaningful assessment of obligor and transaction characteristics, a meaningful differentiation of risk and accurate and consistent quantitative estimates of risk;

2. (2)

   internal ratings and default and loss estimates used in the calculation of capital requirements and associated systems and processes play an essential role in the risk management and decision-making process, and in the credit approval, internal capital allocation and corporate governance functions of the firm;

3. (3)

   the firm has a credit risk control unit responsible for its rating systems that is appropriately independent and free from undue influence;

4. (4)

   the firm collects and stores all relevant data to provide effective support to its credit risk measurement and management process; and

5. (5)

   the firm documents its rating systems, the rationale for their design and validates its rating systems.

[Note:BCD Article 84(2) (part)]

Where an EEA parent institution3 and its subsidiary undertakings or an EEA parent financial holding company3 and its subsidiary undertakings use the IRB approach on a unified basis, the question whether the minimum IRB standards are met is answered by considering the parent undertaking and its subsidiary undertakings together unless the firm'sIRB permission specifies otherwise.

[Note: BCD Article 84(2) (part)]

If a firm uses separate models for the purpose of the IRB approach and for its internal purposes as referred to in BIPRU 4.2.2 R (2) it must be able to demonstrate the reasonableness of any differences between those models.

A firm must be able to demonstrate that it has been using for the IRB exposure classes in question rating systems that were broadly in line with the minimum IRB standards for internal risk measurement and management purposes for at least three years prior to the date of its IRB permission.

[Note:BCD Article 84(3)]

A firm that has applied for the use of own estimates of LGDs and/or conversion factors must be able to demonstrate to the FSA that it has been estimating and employing own estimates of LGDs and/or conversion factors in a manner that was broadly consistent with the minimum IRB standards for use of own estimates of those parameters for at least three years prior to the date of its IRB permission or of a variation of its IRB permission that, in either case, entitled the firm to use own estimates of LGDs and/or conversion factors.

[Note:BCD Article 84(4)]

A firm must comply with any requirements in its IRB permission relating to the matters described in BIPRU 4.2.17 R - BIPRU 4.2.35 G.

Without prejudice to BIPRU 4.2.26 R, a firm and any parent undertaking and its subsidiary undertakings must implement the IRB approach for all exposures.

[Note: BCD Article 85(1) (part)]

To the extent that a firm'sIRB permission permits this, implementation may be carried out sequentially across the different IRB exposure classes within the same business unit, across different business units in the same group or for the use of own estimates of LGDs or conversion factors for the calculation of risk weights for the sovereign, institution and corporate IRB exposure class.3

[Note:BCD Article 85(1) (part)]

In the case of the retail exposures, implementation may (but only to the extent provided for in the firm'sIRB permission) be carried out sequentially across the categories of exposures to which the different correlations in BIPRU 4.6.41 R-BIPRU 4.6.44 R correspond.

[Note:BCD Article 85(1) (part)]

1. (1)

   Implementation of the IRB approach as referred to in BIPRU 4.2.18 R must be carried out within a reasonable period of time as set out in the IRB permission.

2. (2)

   The implementation must be carried out subject to strict conditions determined by the FSA and set out in the IRB permission.

3. (3)

   A firm must not use the flexibility under BIPRU 4.2.18 R selectively with the purpose of achieving reduced minimum capital requirements in respect of those IRB exposure classes or business units that are yet to be included in the IRB approach or in the use of own estimates of LGDs and conversion factors.

[Note:BCD Article 85(2)]

A firm using the IRB approach for any IRB exposure class must at the same time use the IRB approach for the equity exposure class.

[Note:BCD Article 85(3)]

Subject to BIPRU 4.2.17 R - BIPRU 4.2.20 R, BIPRU 4.2.22 R and BIPRU 4.2.26 R, a firm that has an IRB permission must not use the standardised approach for the calculation of risk weighted exposure amounts for the exposures to which the IRB approach applies under the IRB permission.

[Note:BCD Article 85(4)]1

Subject to BIPRU 4.2.17 R - BIPRU 4.2.22 R and BIPRU 4.2.26 R, a firm whose IRB permission provides for the use of the advanced IRB approach for the calculation of LGDs and conversion factors for the sovereign, institution and corporate IRB exposure class must not use the LGD values and conversion factors applicable to the foundation IRB approach for the exposures to which the advanced IRB approach applies under the IRB permission.

[Note:BCD Article 85(5)]

1. (1)

   To the extent that its IRB permission permits this, a firm permitted to use the IRB approach in the calculation of risk weighted exposure amounts and expected loss amounts3 for one or more IRB exposure classes may apply the standardised approach in accordance with this rule.

   3
2. (2)

   A firm may apply the standardised approach to the IRB exposure class referred to in BIPRU 4.3.2 R (1) (Sovereigns) where the number of material counterparties is limited and it would be unduly burdensome for the firm to implement a rating system for these counterparties. A firm may include in this treatment an exposure of the type described in BIPRU 3.4.18 R (Exposures to churches or religious communities) that would fall within BIPRU 3.4.15 R or BIPRU 3.4.17 R (Exposure to a regional government or local authority) if those provisions had not been excluded by BIPRU 3.4.18 R.

3. (3)

   A firm may apply the standardised approach to the IRB exposure class referred to in BIPRU 4.3.2 R (2) (Institutions), where the number of material counterparties is limited and it would be unduly burdensome for the firm to implement a rating system for these counterparties.

4. (4)

   A firm may apply the standardised approach to exposures in non-significant business units as well as IRB exposure classes that are immaterial in terms of size and perceived risk profile.

5. (5)

   A firm may apply the standardised approach to exposures to the central government of the United Kingdom and to its regional governments, local authorities and administrative bodies, provided that:

   1. (a)

      there is no difference in risk between the exposures to the central government and those other exposures because of specific public arrangements; and

   2. (b)

      exposures to the central government are assigned a 0% risk weight under the standardised approach.

6. (6)

   A firm may apply the standardised approach to exposures of a firm to a counterparty which is its parent undertaking, its subsidiary undertaking or a subsidiary undertaking of its parent undertaking provided that the counterparty is an institution, a financial holding company, a financial institution, an asset management company or an ancillary services undertaking subject to appropriate prudential requirements.

7. (7)

   A firm may apply the standardised approach to equity exposures to entities whose credit obligations qualify for a 0% risk weight under the standardised approach (including those publicly sponsored entities where a zero risk weight can be applied).

8. (8)

   A firm may apply the standardised approach to equity exposures incurred under legislative programmes to promote specified sectors of the economy that provide significant subsidies for the investment to the firm and involve some form of government oversight and restrictions on the equity investments. This exclusion is limited to an aggregate of 10% of capital resources.

9. (9)

   A firm may apply the standardised approach to the exposures identified in BIPRU 3.4.48 R (Exposures in the form of minimum reserves required by the European Central Bank or by the central bank of an EEA State) meeting the conditions specified therein.

10. (10)

    A firm may apply the standardised approach to state and state-reinsured guarantees pursuant to BIPRU 5.7.12 R (Conditions for state and state-reinsured guarantees).

[Note:BCD Article 89(1)]

For the purposes of BIPRU 4.2.26 R (4), the equity exposureIRB exposure class of a firm must be considered material if its aggregate value, excluding equity exposures incurred under legislative programmes as referred to in BIPRU 4.2.26 R (8), exceeds, on average over the preceding year, 10% of the firm'scapital resources. If the number of those equity exposures is less than 10 individual holdings, that threshold is 5% of the firm'scapital resources.

[Note:BCD Article 89(2)]

1. (1)

   This rule sets out what must be treated as being non-significant business or immaterial for the purposes of BIPRU 4.2.26 R (4), for exposures that do not fall within the equity exposureIRB exposure class.

2. (2)

   A firm may elect permanently to exclude exposures from the IRB approach and apply the standardised approach. However a firm may only make use of this exemption to the extent that:

   1. (a)

      the consolidated credit risk requirement (adjusted under (6)) so far as it is attributable to the excluded exposures;

   would be no more than 15% of:

   1. (b)

      the consolidated credit risk requirement (adjusted under (6)) with respect to all exposures (including the ones dealt with under (a)).

3. (3)

   Exposures excluded under BIPRU 4.2.29 R or BIPRU 4.2.26 R (2), BIPRU 4.2.26 R (3) and BIPRU 4.2.26 R (5)-BIPRU 4.2.26 R (7) must not be included in (a) or (b).

4. (4)

   The calculation in (2)(a) is based on the standardised approach.

5. (5)

   The calculation in (2)(b) is based on whichever of the standardised approach and the IRB approach would apply to the exposures referred to in (2)(b) at the time when the calculation is being made.

6. (6)

   The consolidated credit risk requirement is adjusted for the purposes of this rule as follows:

   1. (a)

      the element based on the concentration risk capital component is excluded, with only the elements based on the credit risk capital component and the counterparty risk capital component being taken into account; and

   2. (b)

      the calculation is carried out with respect to the group of undertakings referred to in BIPRU 4.2.17 R.

7. (7)

   If a group with respect to which the calculation in this rule is being carried out is not required to calculate the consolidated credit risk requirement, the calculations in this rule must be carried out as if it were.

If a firm applies to use the advanced IRB approach for the sovereign, institution and corporate IRB exposure class, BIPRU 4.2.26 R (4) also applies with respect to exposures in that class. For these purposes, to the extent permitted in the firm'sIRB permission, a firm may:

1. (1)

   exclude some exposures from the IRB approach and apply the standardised approach to those exposures; and

2. (2)

   exclude other exposures from the advanced IRB approach and apply the foundation IRB approach to those exposures.

This section applies to all exposures treated under the IRB approach.

Each exposure must be assigned to one of the following exposure classes:

1. (1)

   claims or contingent claims on central governments and central banks;

2. (2)

   claims or contingent claims on institutions;

3. (3)

   claims or contingent claims on corporates;

4. (4)

   retail claims or contingent retail claims;

5. (5)

   equity claims;

6. (6)

   securitisation positions; and

7. (7)

   non credit-obligation assets.

[Note: BCD Article 86(1)]

The methodology used by a firm for assigning exposures to different IRB exposure classes must be appropriate and consistent over time.

[Note: BCD Article 86(9)]

The risk weighted exposure amounts for credit risk for exposures belonging to one of the exposure classes referred to in (1) to (4) must, unless deducted from capital resources, be calculated in accordance with the following provisions:

1. (1)

   for exposures in the sovereign, institution and corporate IRB exposure class, BIPRU 4.4.57 R to BIPRU 4.4.60 R, BIPRU 4.4.79 R, BIPRU 4.5.8 R to BIPRU 4.5.10 R (for specialised lending exposures), BIPRU 4.9.3 R and BIPRU 4.8.16 R to BIPRU 4.8.17 R (for purchased corporate exposure receivables);

2. (2)

   for exposures in the retail exposureclass, BIPRU 4.6.41 R to BIPRU 4.6.44 R, BIPRU 4.6.57 R and BIPRU 4.8.18 R to BIPRU 4.8.20 R (for purchased retail exposure receivables);

3. (3)

   for exposures in the equity exposureclass, BIPRU 4.7.5 R to BIPRU 4.7.6 R, BIPRU 4.7.9 R to BIPRU 4.7.11 R, BIPRU 4.7.14 R to BIPRU 4.7.16 R and BIPRU 4.7.24 R to BIPRU 4.7.25 R; and

4. (4)

   for exposures in the non credit-obligation assetsexposureclass, BIPRU 4.9.6 R.

[Note: BCD Article 87(1)]

The calculation of risk weighted exposure amounts for credit risk and dilution risk must be based on the relevant parameters associated with the exposure in question. These include probability of default (PD), loss given default (LGD), maturity (M) and the exposure value of the exposure. PD and LGD may be considered separately or jointly, in accordance with the provisions relating to PD and LGD in BIPRU 4.4, BIPRU 4.6, BIPRU 4.7 and BIPRU 4.8 at:

1. (1)

   for exposures in the sovereign, institution and corporate IRB exposure class, BIPRU 4.4.34 R - BIPRU 4.4.35 R, BIPRU 4.4.42 R to BIPRU 4.4.43 R, BIPRU 4.4.63 R - BIPRU 4.4.66 R, BIPRU 4.4.80 R and, for PD and LGD for dilution risk of purchased corporate exposure receivables, BIPRU 4.8.23 Rand BIPRU 4.8.26 R;

2. (2)

   for exposures in the retail exposure class, BIPRU 4.6.50 R - BIPRU 4.6.54 R, BIPRU 4.6.58 R, and, for PD and LGD for dilution risk of purchased retail exposure receivables, BIPRU 4.8.24 R and BIPRU 4.8.27 R; and

3. (3)

   for exposures in the equity exposure class, BIPRU 4.7.18 R and BIPRU 4.7.20 R - BIPRU 4.7.21 R.

[Note: BCD Article 87(3)]

The expected loss amounts for exposures belonging to one of the IRB exposure classes referred to in (1) to (3) must be calculated in accordance with the methods set out in the following provisions:

1. (1)

   for exposures in the sovereign, institution and corporate IRB exposure class, BIPRU 4.4.61 R to BIPRU 4.4.62 R and (for specialised lending exposures) BIPRU 4.5.13 R to BIPRU 4.5.15R;

2. (2)

   for exposures in the retail exposure class, BIPRU 4.6.47 R to BIPRU 4.6.48 R;

3. (3)

   for exposures in the equity exposure class, BIPRU 4.7.12 R, BIPRU 4.7.17 R and BIPRU 4.7.26 R; and

4. (4)

   (for purchased receivables falling into one of the IRB exposure classes in (1) to (3)) BIPRU 4.8.30 R.

[Note:BCD Article 88(1)]

The calculation of expected loss amounts in accordance with BIPRU 4.3.6 R must be based on the same input figures of PD, LGD and the exposure value for each exposure as being used for the calculation of risk weighted exposure amounts in accordance with BIPRU 4. For defaultedexposures,where a firm uses its own estimate of LGDs, EL must be the firm's best estimate of expected loss (EL_BE), for the defaultedexposure in accordance with BIPRU 4.3.122 R.

[Note:BCD Article 88(2)]

The expected loss amounts calculated in accordance with BIPRU 4.3.6 R (1), BIPRU 4.3.6 R (2) and BIPRU 4.3.6 R (4) must be subtracted from the sum of value adjustments and provisions related to these exposures. Discounts on balance sheet exposures purchased when in default according to BIPRU 4.4.71 R must be treated in the same manner as value adjustments. Expected loss amounts for securitised exposures and value adjustments and provisions related to these exposures must not be included in this calculation.

[Note:BCD Annex VII Part 1 point 36]

All material aspects of the rating and estimation processes must be approved by the firm'sgoverning body or a designated committee thereof and senior management. These parties must possess a general understanding of the firm'srating systems and detailed comprehension of its associated management reports.

[Note: BCD Annex VII Part 4 point 124]

Senior management must provide notice to the governing body or a designated committee thereof of material changes or exceptions from established policies that will materially impact the operations of the firm'srating systems.

[Note:BCD Annex VII Part 4 point 125]

Senior management must have a good understanding of the rating system's designs and operations. Senior management must ensure on an ongoing basis that the rating systems are operating properly. Senior management must be regularly informed by the credit risk control units about the performance of the rating process, areas needing improvement, and the status of efforts to improve previously identified deficiencies.

[Note:BCD Annex VII Part 4 point 126]

Internal ratings-based analysis of the firm's credit risk profile must be an essential part of the management reporting required under BIPRU 4.3.9 R, BIPRU 4.3.11 R and BIPRU 4.3.13 R. Reporting must include at least risk profile by grade, migration across grades, estimation of the relevant parameters per grade, and comparison of realised default rates and, to the extent that own estimates are used, of realised LGDs and realised conversion factors against expectations and stress-test results. Reporting frequencies must depend on the significance and type of information and the level of the recipient.

[Note:BCD Annex VII Part 4 point 127]

The credit risk control unit must be independent from the personnel and management functions responsible for originating or renewing exposures and report directly to senior management. The unit must be responsible for the design or selection, implementation, oversight and performance of the rating systems. It must regularly produce and analyse reports on the output of the rating systems.

[Note:BCD Annex VII Part 4 point 128]

The areas of responsibility for the credit risk control unit(s) must include the following:

1. (1)

   testing and monitoring grades and pools;

2. (2)

   production and analysis of summary reports from the firm'srating systems;

3. (3)

   implementing procedures to verify that grade and pool definitions are consistently applied across departments and geographic areas;

4. (4)

   reviewing and documenting any changes to the rating process, including the reasons for the changes;

5. (5)

   reviewing the rating criteria to evaluate if they remain predictive of risk (and changes to the rating process, criteria or individual rating parameters must be documented and retained);

6. (6)

   active participation in the design or selection, implementation and validation of models used in the rating process;

7. (7)

   oversight and supervision of models used in the rating process; and

8. (8)

   ongoing review and alterations to models used in the rating process.

[Note:BCD Annex VII Part 4 point 129]

Notwithstanding BIPRU 4.3.16 R, a firm using pooled data according to BIPRU 4.3.92 R - BIPRU 4.3.94 R (Overall requirements for estimation) may outsource the following tasks:

1. (1)

   production of information relevant to testing and monitoring grades and pools;

2. (2)

   production of summary reports from the firm'srating systems;

3. (3)

   production of information relevant to review of the rating criteria to evaluate if they remain predictive of risk;

4. (4)

   documentation of changes to the rating process, criteria or individual rating parameters; and

5. (5)

   production of information relevant to ongoing review and alterations to models used in the rating process.

[Note:BCD Annex VII Part 4 point 130 (part)]

A firm making use of BIPRU 4.3.17 R must ensure that the FSA has access to all relevant information from the third party that is necessary for examining compliance with the minimum IRB standards and the firm'sIRB permission and that the FSA may perform on-site examinations to the same extent as within the firm.

[Note:BCD Annex VII Part 4 point 130 (part)]

A firm must document the design and operational details of its rating systems. The documentation must evidence compliance with the minimum IRB standards and the firm'sIRB permission, and address topics including portfolio differentiation, rating criteria, responsibilities of parties that rate obligors and exposures, frequency of assignment reviews, and management oversight of the rating process.

[Note:BCD Annex VII Part 4 point 31]

A firm must ensure that all documentation relating to its rating systems or otherwise required by the rules governing the IRB approach are stored, arranged and indexed in such a way that the firm would be able to make them all available to the FSA, or to make any class or description of them specified by the FSA available to the FSA, immediately on demand or within a short time thereafter.

A firm must document the rationale for and analysis supporting its choice of rating criteria. A firm must document all major changes in the risk rating process, and such documentation must support identification of changes made to the risk rating process subsequent to the last review by the FSA. The organisation of rating assignment including the rating assignment process and the internal control structure must also be documented.

[Note:BCD Annex VII Part 4 point 32]

A firm must document the specific definitions of default and loss used internally and demonstrate consistency with the definitions of default and loss set out in the glossary and BIPRU 4.

[Note:BCD Annex VII Part 4 point 33]

Where a firm employs statistical models in the rating process, the firm must document its methodologies. This material must:

1. (1)

   provide a detailed outline of the theory, assumptions and/or mathematical and empirical basis of the assignment of estimates to grades, individual obligors, exposures, or pools, and the data source(s) used to estimate the model;

2. (2)

   establish a rigorous statistical process (including out-of-time and out-of-sample performance tests) for validating the model; and

3. (3)

   indicate any circumstances under which the model does not work effectively.

[Note:BCD Annex VII Part 4 point 34]

A rating system comprises all of the methods, processes, controls, data collection and IT systems that support the assessment of credit risk, the assignment of exposures to grades or pools (rating), and the quantification of default and loss estimates for a certain type of exposure.

[Note:BCD Annex VII Part 4 point 1]

If a firm uses multiple rating systems, the rationale for assigning an obligor or a transaction to a rating system must be documented and applied in a manner that appropriately reflects the level of risk.

[Note:BCD Annex VII Part 4 point 2]

Assignment criteria and processes must be periodically reviewed to determine whether they remain appropriate for the current portfolio and external conditions.

[Note:BCD Annex VII Part 4 point 3]

Where a firm uses direct estimates of risk parameters these may be seen as the outputs of grades on a continuous rating scale.

[Note:BCD Annex VII Part 4 point 4]

A firm must have robust systems in place to validate the accuracy and consistency of rating systems, processes, and the estimation of all relevant risk parameters (PD, LGD, conversion factors and EL). A firm must be able to demonstrate to the FSA that the internal validation process enables it to assess the performance of internal rating and risk estimation systems consistently and meaningfully.

[Note:BCD Annex VII Part 4 point 110]

1. (1)

   A firm must validate its rating systems. Its validation process must include, as a minimum, the elements set out in (2) - (8).

2. (2)

   A firm must establish and define standards of objectivity, accuracy, stability and conservatism that it designs its ratings systems to meet. It must have processes that establish whether its rating systems meet those standards.

3. (3)

   A firm must establish and define standards of accuracy of calibration (i.e. whether outcomes are consistent with estimate) and discriminative power (i.e. the ability to rank-order risk) that it designs its rating systems to meet. It must have processes that establish whether its rating systems meet those standards.

4. (4)

   A firm must have polices and standards that specify the actions to be taken when a rating system fails to meet the standards of accuracy and discriminative power referred to in (2) and (3).

5. (5)

   A firm's validation process must include a mix of developmental evidence, benchmarking and process verification. A firm's validation process must include policies on how this mixture varies between different rating systems.

6. (6)

   A firm's validation process must include the use of both quantitative and qualitative techniques.

7. (7)

   A firm's validation process must include policies on how validation procedures are expected to vary over time.

8. (8)

   A firm's validation process must include independent input into and review of its rating systems.

9. (9)

   The standards set under (2) and (3) must meet the minimum IRB standards.

10. (10)

    For the purpose of (5):

    1. (a)

       developmental evidence means evidence that substantiates whether the logic and quality of a rating system (including the quantification process) adequately discriminates between different levels of, and delivers accurate estimates of PD, EL, LGD and conversion factors (as applicable); and

    2. (b)

       process verification means the process of establishing whether the methods used in a rating system to discriminate between different levels of risk and to quantify PD, EL, LGD and conversion factors are being used, monitored and updated in the way intended in the design of the rating system.

A firm must regularly compare realised default rates with estimated PDs for each grade and where realised default rates are outside the expected range for that grade a firm must specifically analyse the reasons for the deviation. A firm3using its own estimates of LGDs and/or conversion factors must also perform analogous analysis for own estimates of LGDs and conversion factors. Such comparisons must make use of historical data that cover as long a period as possible. A firm must document the methods and data used in such comparisons. This analysis and documentation must be updated at least annually.

[Note:BCD Annex VII Part 4 point 111]

A firm must also use other appropriate quantitative validation tools and comparisons with relevant external data sources. The analysis must be based on data that is appropriate to the portfolio, is updated regularly, and covers a relevant observation period. A firm's internal assessments of the performance of its rating systems must be based on as long a period as possible.

[Note:BCD Annex VII Part 4 point 112]

The methods and data used for quantitative validation must be consistent through time. Changes in estimation and validation methods and data (both data sources and periods covered) must be documented.

[Note:BCD Annex VII Part 4 point 113

A firm must have sound internal standards for situations where deviations in realised PDs, LGDs, conversion factors and, where EL is used, total losses, from expectations become significant enough to call the validity of the estimates into question. These standards must take account of business cycles and similar systematic variability in default and loss experience. Where realised values continue to be higher than expected values, a firm must revise estimates upward to reflect its default and loss experience.

[Note:BCD Annex VII Part 4 point 114]

Internal audit or another comparable independent auditing unit must review at least annually the firm'srating systems and its operations, including the operations of the firm and the estimation of PDs, LGDs, ELs and conversion factors. Areas of review must include adherence to all applicable minimum requirements.

[Note:BCD Annex VII Part 4 point 131]

A firm must have in place sound stress testing processes for use in the assessment of its capital adequacy. Stress testing must involve identifying possible events or future changes in economic conditions that could have unfavourable effects on the firm's credit exposures and assessment of the firm's ability to withstand such changes.

[Note:BCD Annex VII Part 4 point 40]

1. (1)

   A firm must regularly perform a credit risk stress test to assess the effect of certain specific conditions on its total capital requirements for credit risk. The test to be employed must be one chosen by the firm. The test to be employed must be meaningful and reasonably conservative. Stressed portfolios must contain the vast majority of a firm's total exposures covered by the IRB approach.

2. (2)

   The stress test must be designed to assess the firm's ability to meet its capital requirements for credit risk under GENPRU 2.1 during all stages of the economic cycle and during an economic downturn scenario based on forward looking hypothetical events calibrated against the most adverse movements in individual risk drivers experienced over a long historical period.4

   4
3. (3)

   In particular the stress test must address the impact (including by ratings migration) of changes in the credit quality of its credit risk counterparties including its protection providers. A firm using the treatment set out in BIPRU 4.4.79 R must in particular consider the impact of protection providers falling outside the eligibility criteria.

4. (4)

   The stress test must be conducted on the basis of the firm'sexposures (on- and off-balance sheet) as they stand at the time of the stress test.

5. (5)

   The stress test must be carried out at least annually and also in the event of a significant change in the state of the economy.

6. (6)

   A firm need not assume that the recession referred to in (2) will occur in the 12 months immediately following the stress test. Instead, the stress test must incorporate a plausible time horizon for the occurrence of the cyclical deterioration of the severity tested for. A firm need not assume that the downturn will occur for all portfolios in all jurisdictions simultaneously.

[Note:BCD Annex VII Part 4 points 41 and 42]

A firm must have specific definitions, processes and criteria for assigning exposures to grades or pools within a rating system.

[Note:BCD Annex VII Part 4 point 17 (part)]

The grade or pool definitions and criteria must be sufficiently detailed to allow those charged with assigning ratings consistently to assign obligors or facilities posing similar risk to the same grade or pool. This consistency must exist across lines of business, departments and geographic locations within each rating system.

[Note:BCD Annex VII Part 4 point 17 (part)]

The documentation of the rating process must allow third parties to understand the assignments of exposures to grades or pools, to replicate grade and pool assignments and to evaluate the appropriateness of the assignments to a grade or a pool.

[Note:BCD Annex VII Part 4 point 17 (part)]

The criteria referred to in BIPRU 4.3.43 R must also be consistent with the firm's internal lending standards and its policies for handling troubled obligors and facilities.

[Note:BCD Annex VII Part 4 point 17 (part)]

A firm must take all relevant information into account in assigning obligors and facilities to grades or pools. Information must be current and must enable the firm to forecast the future performance of the exposure. The less information a firm has, the more conservative must be its assignments of exposures to obligor and facility grades or pools. If a firm uses an external rating as a primary factor determining an internal rating assignment, the firm must ensure that it considers other relevant information.

[Note:BCD Annex VII Part 4 point 18]

For grade and pool assignments a firm must document the situations in which human judgement may override the inputs or outputs of the assignment process and the personnel responsible for approving these overrides. A firm must document these overrides and the personnel responsible. A firm must analyse the performance of the exposures whose assignments have been overridden. This analysis must include assessment of the performance of exposures whose rating has been overridden by a particular person, accounting for all the responsible personnel.

[Note:BCD Annex VII Part 4 point 25]

1. (1)

   This paragraph applies to the use of statistical models and/or other mechanical methods to assign exposures to obligor grades, obligor pools, facility grades or facility pools.

2. (2)

   A firm must be able to demonstrate to the FSA that the model has good predictive power and that capital requirements are not distorted as a result of its use.

3. (3)

   The input variables to the model must form a reasonable and effective basis for the resulting predictions. The model must not have material biases.

4. (4)

   A firm must have in place a process for vetting data inputs into the model, which includes an assessment of the accuracy, completeness and appropriateness of the data.

5. (5)

   A firm must be able to demonstrate to the FSA that the data used to build the model is representative of the population of the firm's actual obligors or exposures.

6. (6)

   A firm must have a regular cycle of model validation that includes monitoring of model performance and stability, review of model specification and testing of model outputs against outcomes.

7. (7)

   A firm must complement the statistical model by human judgement and human oversight to review model-based assignments and to ensure that the models are used appropriately. Review procedures must aim at finding and limiting errors associated with model weaknesses. Human judgements must take into account all relevant information not considered by the model. A firm must document how human judgement and model results are to be combined.

8. (8)

   Use of a model obtained from a third-party vendor that claims proprietary technology is not a justification for exemption from documentation or any other of the requirements in BIPRU 4 or a firm'sIRB permission for rating systems. A firm must be able to satisfy the FSA that all those requirements are satisfied if it uses such a model.

[Note:BCD Annex VII Part 4 points 30 and 35 (part)]

A firm must collect and store data on aspects of its internal ratings as required under BIPRU 11 (Disclosure).

[Note:BCD Annex VII Part 4 point 36]

A default must be considered to have occurred with regard to a particular obligor when either or both of the two following events has taken place:

1. (1)

   the firm considers that the obligor is unlikely to pay its credit obligations to the firm, the parent undertaking or any of its subsidiary undertakings in full, without recourse by the firm to actions such as realising security (if held); and

2. (2)

   the obligor is past due more than 90 days on any material credit obligation to the firm, the parent undertaking or any of its subsidiary undertakings.

[Note:BCD Annex VII Part 4 point 44 (part)]

The following provisions also apply with respect to the definition of default:

1. (1)

   for overdrafts, days past due commence once an obligor has breached an advised limit, has been advised a limit smaller than current outstandings, or has drawn credit without authorisation and the underlying amount is material;

2. (2)

   an advised limit means a limit which has been brought to the knowledge of the obligor;

3. (3)

   days past due for credit cards commence on the minimum payment due date;

4. (4)

   in the case of retail exposures and exposures to public sector entities the number of days past due is as set out in BIPRU 4.4.22 R and BIPRU 4.6.20 R; and

5. (5)

   in all cases for the purposes of the definition of default, a credit obligation or, for overdrafts, the underlying amount, is material if, when added to the other exposures of the obligor, the total exceeds the amount which the firm treats as a material default for its internal risk measurement and management purposes.

[Note:BCD Annex VII Part 4 point 44 (part)]

Where a firm applies the definition of default at facility level in accordance with BIPRU 4.6.21 R, it should define materiality for the purposes of BIPRU 4.3.57 R (5) by reference to the facility amount only, disregarding other exposures of the obligor.

A firm must have a policy which sets out how it will determine whether a credit obligation or, for overdrafts, the underlying amount, is material for the purposes of the definition of default in BIPRU 4.3.56 R (2) and BIPRU 4.3.57 R (5).

1. (1)

   Elements to be taken as indications of unlikeliness to pay must include the items set out in this rule.

2. (2)

   The firm putting the credit obligation on non-accrued status must be taken as an indication of unlikeliness to pay.

3. (3)

   The firm making a value adjustment resulting from a significant perceived decline in credit quality subsequent to the firm taking on the exposure must be taken as an indication of unlikeliness to pay.

4. (4)

   The firm selling the credit obligation at a material credit-related economic loss must be taken as an indication of unlikeliness to pay.

5. (5)

   The firm consenting to a distressed restructuring of the credit obligation must be taken as an indication of unlikeliness to pay where this is likely to result in a diminished financial obligation caused by the material forgiveness, or postponement, of principal, interest or (where relevant) fees. This includes in the case of equity exposures assessed under a PD/LGD approach, distressed restructuring of the equity itself.

6. (6)

   The firm having filed for the obligor's bankruptcy or a similar order in respect of an obligor's credit obligation to the firm, the parent undertaking or any of its subsidiary undertakings must be taken as an indication of unlikeliness to pay.

7. (7)

   The obligor seeking or having been placed in bankruptcy or similar protection where this would avoid or delay repayment of a credit obligation to the firm, the parent undertaking or any of its subsidiary undertakings must be taken as an indication of unlikeliness to pay.

[Note:BCD Annex VII Part 4 point 45]

A firm must (if it uses external data that is not itself consistent with the definition of default) be able to demonstrate to the FSA that appropriate adjustments have been made that achieve broad equivalence with the definition of default.

[Note:BCD Annex VII Part 4 point 46]

If a firm considers that a previously defaultedexposure is such that no trigger of default continues to apply, the firm must rate the obligor or facility as it would for a non-defaultedexposure. Should the definition of default subsequently be triggered, another default must be deemed to have occurred.

[Note:BCD Annex VII Part 4 point 47]

BIPRU 4.3.74 R to BIPRU 4.3.131 R apply to a firm's own estimates of risk parameters used in the IRB approach.

[Note:BCD Annex VII Part 4 point 43]

A firm's own estimates of the risk parameters PD, LGD, conversion factor and EL must incorporate all relevant data, information and methods. The estimates must be derived using both historical experience and empirical evidence, and must not be based purely on judgemental considerations. The estimates must be plausible and intuitive and must be based on the material drivers of the respective risk parameters. The less data a firm has, the more conservative it must be in its estimation.

[Note:BCD Annex VII Part 4 point 49]

1. (1)

   In calculating estimates of PD, LGD and conversion factors a firm must adjust the averages of historical experience referred to in the historical averages rules in order to ensure that those estimates are accurate estimates of the default rate, loss rate or conversion factor over the long-run.

2. (2)

   The historical average rules means the requirements in BIPRU 4 relating to the calculation of PD, LGD and conversion factors using historical averages (and in particular BIPRU 4.4.24 R, BIPRU 4.4.30 R, BIPRU 4.8.7 R, BIPRU 4.8.8 R, BIPRU 4.6.24 R, BIPRU 4.6.27 R, BIPRU 4.3.99 R and BIPRU 4.3.125 R).

1. (1)

   A firm must collect data on what it considers to be the main drivers of the risk parameters PD, LGD, conversion factor and EL for each group of obligors or facilities.

2. (2)

   A firm must document its identification of the main drivers of risk parameters.

3. (3)

   A firm must be able to demonstrate that its process of identification is reasonable and appropriate.

In its processes for identifying the main drivers of risk parameters, a firm must set out its reasons for concluding that the data sources chosen provide in themselves sufficient discriminative power and accuracy and why additional potential data sources do not provide relevant and reliable information that would be expected materially to improve the discriminative power and accuracy of its estimates of the risk parameter in question. This does not require an intensive analysis of all factors.

A firm must be able to provide a breakdown of its loss experience in terms of default frequency, LGD, conversion factor, or loss where EL estimates are used, by the factors it sees as the drivers of the respective risk parameters. A firm must be able to demonstrate to the FSA that its estimates are representative of long-run experience.

[Note:BCD Annex VII Part 4 point 50]

Any changes in lending practice or the process for pursuing recoveries over the observation periods referred to in BIPRU 4.4.31 R (Observation period for sovereigns, institutions and corporates for PDs), BIPRU 4.6.28 R (Observation period for retail exposures for PDs), BIPRU 4.4.54 R (Observation period for sovereigns, institutions and corporates for LGDs), BIPRU 4.6.33 R (Observation period for retail exposures for LGDs), BIPRU 4.4.55 R (Observation period for sovereigns, institutions and corporates for conversion factors) and BIPRU 4.6.38 R (Observation period for retail exposures for conversion factors) must be taken into account. A firm's estimates must reflect the implications of technical advances and new data and other information, as it becomes available. A firm must review its estimates when new information comes to light but at least on an annual basis.

[Note:BCD Annex VII Part 4 point 51]

The population of exposures represented in the data used for estimation, the lending standards used when the data was generated and other relevant characteristics must be comparable with those of a firm'sexposures and standards. A firm must also be able to demonstrate to the FSA that the economic or market conditions that underlie the data are relevant to current and foreseeable conditions. The number of exposures in the sample and the data period used for quantification must be sufficient to provide a firm with confidence in the accuracy and robustness of its estimates.

[Note:BCD Annex VII Part 4 point 52]

A firm must add to its estimates a margin of conservatism that is related to the expected range of estimation errors. Where methods and data are less satisfactory and the expected range of errors is larger, the margin of conservatism must be larger.

[Note:BCD Annex VII Part 4 point 54]

If a firm uses different estimates for the calculation of risk weights and internal purposes it must be documented. The firm must be able to demonstrate to the FSA the reasonableness of such estimates.

[Note:BCD Annex VII Part 4 point 55]

If a firm uses data that is pooled across institutions it must be able to demonstrate to the FSA that:

1. (1)

   the rating systems and criteria of other firms in the pool are similar to its own;

2. (2)

   the pool is representative of the portfolio for which the pooled data is used; and

3. (3)

   the pooled data is used consistently over time by the firm for its permanent estimates.2

[Note:BCD Annex VII Part 4 point 57]

If a firm uses data that is pooled across institutions it remains responsible for the integrity of its rating systems. If a firm uses such data it must be able to demonstrate to the FSA that it has sufficient in-house understanding of its rating systems, including effective ability to monitor and audit the rating process.

[Note:BCD Annex VII Part 4 point 58]

1. (1)

   If:

   1. (a)

      a firm's internal experience of exposures of a type covered by a model or other rating system is 20 defaults or fewer; and

   2. (b)

      in the firm's view, reliable estimates of PD cannot be derived from external sources of default data, including the use of market price related data, for all the exposures covered by the rating system;

   the firm must estimate PD for exposures covered by that rating system in accordance with this rule.

2. (2)

   A firm must use a statistical technique to derive the distribution of defaults implied by the firm's experience, estimating PDs (the "statistical PD") from the upper bound of a confidence interval set by the firm in order to produce conservative estimates of PDs in accordance with BIPRU 4.3.88 R.

3. (3)

   The techniques chosen for the purposes of (2) must take account, as a minimum, of the following modelling issues:

   1. (a)

      the number of defaults and number of obligor years in the sample;

   2. (b)

      the number of years from which the sample was drawn;

   3. (c)

      the interdependence between default events for individual obligors;

   4. (d)

      the interdependence between default rates for different years; and

   5. (e)

      the choice of the statistical estimators and the associated distributions and confidence intervals.

4. (4)

   The firm must further adjust the statistical PD to the extent necessary to take account of the following:

   1. (a)

      any likely differences between the observed default rates over the period covered by the firm'sdefault experience and the long-run PD for each grade in accordance with BIPRU 4.4.24 R and BIPRU 4.6.24 R; and

   2. (b)

      any other information that indicates (taking into account the robustness and cogency of that information) that the statistical PD is likely to be an inaccurate estimate of PD.

5. (5)

   This rule is in addition to the other requirements in BIPRU about the calculation of PD.

6. (6)

   When a firm calculates whether it has 20 defaults or fewer under the calculation in (1)(a), it must only take into account defaults that occurred during periods that are relevant to the validation under BIPRU 4 of the model or other rating system in question.

BIPRU 4.3.98 R to BIPRU 4.3.123 R set out requirements specific to own-LGD estimates.

A firm must estimate LGDs by facility grade or pool on the basis of the average realised LGDs by facility grade or pool using all observed defaults within the data sources (default weighted average).

[Note:BCD Annex VII Part 4 point 73]

A firm must calculate the default weighted average on the basis of the number of defaults included in the calculations made under the historical average rules so far as they relate to the calculation of PDs and must not be weighted by the size of exposures.

1. (1)

   A firm's estimates of LGDs must take into account:

   1. (a)

      data in respect of relevant incomplete workouts; and

   2. (b)

      the possibility that the proportion of defaultedexposures which are cured (as referred to in BIPRU 4.3.71 R) or restructured (as referred to in BIPRU 4.3.63 R (5)) or the length of the period over which a firm makes recoveries under a defaultedexposure may be different from the firm's observed historic experience.

2. (2)

   An incomplete workout as referred to in (1)(a) means a defaultedexposure included in the data set on which the firm'sLGD estimates are based, but for which the recovery process is still in progress, with the result that the final realised losses in respect of that exposure are not yet certain.

A firm must use LGD estimates that are appropriate for an economic downturn if those are more conservative than the long-run average. To the extent a rating system is expected to deliver constant realised LGDs by grade or pool over time, a firm must make adjustments to its estimates of risk parameters by grade or pool to limit the capital impact of an economic downturn.

[Note:BCD Annex VII Part 4 point 74]

1. (1)

   A firm must have a rigorous and well documented process for:

   1. (a)

      assessing the effects, if any, of economic downturn conditions on recovery rates; and

   2. (b)

      producing LGD estimates consistent with downturn conditions as referred to in BIPRU 4.3.103 R.

2. (2)

   That process must include the following, which may be included in an integrated manner:

   1. (a)

      identification of appropriate downturn conditions for each IRB exposure class within each jurisdiction;

   2. (b)

      identification of adverse dependencies, if any, between default rates and recovery rates; and

   3. (c)

      incorporation of adverse dependencies, if identified, between default rates and recovery rates in the firm's estimates of LGD in a manner that meets the requirements in BIPRU 4.3.103 R relating to an economic downturn.

A firm must retain sufficient data on both LGDs calculated on a economic downturn basis and calculated on a long-run average basis (as referred to in BIPRU 4.3.103 R) to be able to demonstrate to the FSA (if asked) that its estimates based on an economic downturn are no less conservative than the long-run average as referred to in that rule.

Irrespective of whether calculated on an economic downturn or long-run average basis, each LGD estimate must be at least zero.

The methods that a firm uses for discounting cash flows for the purposes of estimating LGDs must take account of the uncertainties associated with the receipt of recoveries with respect to a defaulted exposure. If a firm intends to use a discount rate that does not take full account of the uncertainty in recoveries, it must be able to explain by what other process it has taken into account that uncertainty for the purposes of calculating LGDs.

A firm must consider the extent of any dependence between the risk of the obligor with that of the collateral or collateral provider. Cases where there is a significant degree of dependence must be addressed in a conservative manner.

[Note:BCD Annex VII Part 4 point 75]

Currency mismatches between the underlying obligation and the collateral must be treated conservatively in the firm's assessment of LGD.

[Note:BCD Annex VII Part 4 point 76]

To the extent that LGD estimates take into account the existence of collateral, these estimates must not solely be based on the collateral's estimated market value. LGD estimates must take into account the effect of the potential inability of the firm expeditiously to gain control of its collateral and liquidate it.

[Note:BCD Annex VII Part 4 point 77]

To the extent that LGD estimates take into account the existence of collateral, a firm must establish internal requirements for collateral management, legal certainty and risk management that are generally consistent with those set out in BIPRU 5 (Credit risk mitigation) as modified by BIPRU 4.10.

[Note:BCD Annex VII Part 4 point 78]

To the extent that a firm recognises collateral for determining the exposure value for counterparty credit risk according to the CCR standardised method or the CCR internal model method, any amount expected to be recovered from the collateral must not be taken into account in the LGD estimates.

[Note:BCD Annex VII Part 4 point 79]

For the specific case of exposures already in default, a firm must use the sum of its best estimate of expected loss for each exposure given current economic circumstances and exposure status and the possibility of additional unexpected losses during the recovery period.

[Note:BCD Annex VII Part 4 point 80]

To the extent that unpaid late fees have been capitalised in a firm's income statement, they must be added to the firm's measure of exposure and loss.

[Note:BCD Annex VII Part 4 point 81]

BIPRU 4.3.125 R - BIPRU 4.3.131 R set out requirements specific to own-conversion factor estimates.

A firm must estimate conversion factors by facility grade or pool on the basis of the average expected conversion factors by facility grade or pool using all observed defaults within the data sources (default weighted average).

[Note:BCD Annex VII Part 4 point 87]

A firm must use conversion factor estimates that are appropriate for an economic downturn if those are more conservative than the long-run average. To the extent a rating system is expected to deliver realised conversion factors at a constant level by grade or pool over time, a firm must make adjustments to its estimates of risk parameters by grade or pool to limit the capital impact of an economic downturn.

[Note:BCD Annex VII Part 4 point 88]

A firm's estimates of conversion factors must reflect the possibility of additional drawings by the obligor up to and after the time a default event is triggered. The conversion factor estimate must incorporate a larger margin of conservatism where a stronger positive correlation can reasonably be expected between the default frequency and the magnitude of conversion factor.

[Note:BCD Annex VII Part 4 point 89]

In arriving at estimates of conversion factors a firm must consider its specific policies and strategies adopted in respect of account monitoring and payment processing. A firm must also consider its ability and willingness to prevent further drawings in circumstances short of payment default, such as covenant violations or other technical default events.

[Note:BCD Annex VII Part 4 point 90]

A firm must have adequate systems and procedures in place to monitor facility amounts, current outstandings against committed lines and changes in outstandings per obligor and per grade. A firm must be able to monitor outstanding balances on a daily basis.

[Note:BCD Annex VII Part 4 point 91]

If a firm uses different estimates of conversion factors for the calculation of risk weighted exposure amounts and internal purposes it must be documented. The firm must be able to demonstrate their reasonableness to the FSA.

[Note:BCD Annex VII Part 4 point 92]

1. (1)

   This section applies with respect to the sovereign, institution and corporate IRB exposure class.

2. (2)

   The sovereign, institution and corporate IRB exposure class includes specialised lending exposures.

3. (3)

   Both BIPRU 4.4 and BIPRU 4.5 (Specialised lending exposures) apply to specialised lending exposures. A firm may calculate risk weighted exposure amounts for a specialised lending exposure either:

   1. (a)

      (if it is able to do so) in accordance with BIPRU 4.4; or

   2. (b)

      in accordance with BIPRU 4.4 as modified by BIPRU 4.5.

The following exposures must be treated as exposures to central governments and central banks:

1. (1)

   exposures to regional governments, local authorities or public sector entities which are treated as exposures to central governments under the standardised approach; and

2. (2)

   exposures to multilateral development banks and international organisations which attract a risk weight of 0% under the standardised approach.

[Note:BCD Article 86(2)]

The following exposures must be treated as exposures to institutions:

1. (1)

   exposures to regional governments and local authorities which are not treated as exposures to central governments under the standardised approach;

2. (2)

   exposures to public sector entities which are treated as exposures to institutions under the standardised approach;

3. (3)

   exposures to multilateral development banks which do not attract a 0% risk weight under the standardised approach; and

4. (4)

   without prejudice to BIPRU 13.3.13 R and BIPRU 13.8.7 R (Exposures to a central counterparty) exposures to recognised third country investment firms and exposures to recognised clearing houses and designated investment exchanges.

[Note: BCD Article 86(3) and CAD Article 40]

Any credit obligation not assigned to the IRB exposure classes referred to in BIPRU 4.3.2 R (1) (Sovereigns), BIPRU 4.3.2 R (2) (Institutions) and BIPRU 4.3.2 R (4) - BIPRU 4.3.2 R (6) (Retail, equity and securitisations) must be assigned to the corporate exposure class.

[Note:BCD Article 86(7)]

BIPRU 4.4.6 R - BIPRU 4.4.21 R apply in addition to BIPRU 4.3.25 R - BIPRU 4.3.28 R (Rating systems).

A rating system must take into account obligor and transaction risk characteristics.

[Note: BCD Annex VII Part 4 point 5]

A rating system must have an obligor rating scale which reflects exclusively quantification of the risk of obligor default. The obligor rating scale must have a minimum of seven grades for non-defaulted obligors and one for defaulted obligors.

[Note:BCD Annex VII Part 4 point 6]

An obligor grade means for the purpose of BIPRU 4 as it applies to the sovereign, institution and corporate IRB exposure class a risk category within a rating system's obligor rating scale, to which obligors are assigned on the basis of a specified and distinct set of rating criteria, from which estimates of PD are derived. A firm must document both the relationship between obligor grades in terms of the level of default risk each grade implies and the criteria used to distinguish that level of default risk.

[Note:BCD Annex VII Part 4 point 7]

A firm with portfolios concentrated in a particular market segment and range of default risk must have enough obligor grades within that range to avoid undue concentrations of obligors in a particular grade. Significant concentrations within a single grade must be supported by convincing empirical evidence that the obligor grade covers a reasonably narrow PD band and that the default risk posed by all obligors in the grade falls within that band.

[Note:BCD Annex VII Part 4 point 8]

Each obligor must be assigned to an obligor grade as part of the credit approval process.

[Note:BCD Annex VII Part 4 point 19]

Each separate legal entity to which a firm is exposed must be separately rated. A firm must be able to demonstrate to the FSA that it has acceptable policies regarding the treatment of individual obligor clients and groups of connected clients.

[Note:BCD Annex VII Part 4 point 22]

Separate exposures to the same obligor must be assigned to the same obligor grade, irrespective of any differences in the nature of each specific transaction. Exceptions, where separate exposures are allowed to result in multiple grades for the same obligor are:

1. (1)

   country transfer risk, this being dependent on whether the exposures are denominated in local or foreign currency;

2. (2)

   where the treatment of associated guarantees to an exposure may be reflected in an adjusted assignment to an obligor grade; and

3. (3)

   where consumer protection, bank secrecy or other legislation prohibit the exchange of client data.

[Note:BCD Annex VII Part 4 point 23]

Assignments and periodic reviews of assignments must be completed or approved by an independent party that does not directly benefit from decisions to extend the credit.

[Note:BCD Annex VII Part 4 point 26]

A firm must update assignments at least annually. High risk obligors and problem exposures must be subject to more frequent review. A firm must undertake a new assignment if material information on the obligor or exposure becomes available.

[Note:BCD Annex VII Part 4 point 27]

A firm must have an effective process to obtain and update relevant information on obligor characteristics that affect PDs, and on transaction characteristics that affect LGDs and conversion factors.

[Note:BCD Annex VII Part 4 point 28]

In addition to complying with the material in BIPRU 4.3.54 R (Data maintenance) a firm must collect and store:

1. (1)

   complete rating histories on obligors and recognised guarantors;

2. (2)

   the dates the ratings were assigned;

3. (3)

   the key data and methodology used to derive the rating;

4. (4)

   the person responsible for the rating assignment;

5. (5)

   the identity of obligors and exposures that defaulted;

6. (6)

   the date and circumstances of such defaults;

7. (7)

   data on the PDs and realised default rates associated with rating grades and ratings migration; and

8. (8)

   (in the case of a firm not using the advanced IRB approach in the calculation of LGDs and/or conversion factors) data on comparisons of realised LGDs to the values as set out in BIPRU 4.4.34 R and BIPRU 4.8.25 R and realised conversion factors to the values as set out in BIPRU 4.4.37 R, BIPRU 4.4.45 R and BIPRU 4.6.44 R.

[Note:BCD Annex VII Part 4 point 37]

1. (1)

   This rule, in accordance with BIPRU 4.3.57 R (4) (Definition of default), sets the exact number of days past due that a firm should abide by in the case of exposures to PSEs.

2. (2)

   For counterparts that are PSEs situated within the United Kingdom the number of days past due is 180.

3. (3)

   For counterparts that are PSEs situated in another EEA State the number of days past due is the lower of:

   1. (a)

      180; and

   2. (b)

      the number of days past due fixed under the CRD implementation measure with respect to point 48 of Part 4 of Annex VII of the Banking Consolidation Directive for that EEA State for such exposures.

4. (4)

   For counterparts that are PSEs in a state outside the EEA the number of days past due is the lower of:

   1. (a)

      180; and

   2. (b)

      (if a number of days past due for such exposures has been fixed under any law of that state applicable to undertakings in the banking sector or the investment services sector that implements the IRB approach) that number.

[Note:BCD Annex VII Part 4 point 44 (part) and point 48 (part)]

BIPRU 4.4.24 R - BIPRU 4.4.31 R apply to both the foundation IRB approach and the advanced IRB approach.

A firm must estimate PDs by obligor grade from long run averages of one-year default rates.

[Note:BCD Annex VII Part 4 point 59]

A firm must use PD estimation techniques only with supporting analysis. A firm must recognise the importance of judgmental considerations in combining results of techniques and in making adjustments for limitations of techniques and information.

[Note:BCD Annex VII Part 4 point 62]

To the extent that a firm uses data on internal default experience for the estimation of PDs it must be able to demonstrate in its analysis that the estimates are reflective of underwriting standards and of any differences in the rating system that generated the data and the current rating system. Where underwriting standards or rating systems have changed, a firm must add a greater margin of conservatism in its estimate of PD.

[Note:BCD Annex VII Part 4 point 63]

To the extent that a firm associates or maps its internal grades to the scale used by an ECAI or similar organisations and then attributes the default rate observed for the external organisation's grades to the firm's grades, mappings must be based on a comparison of internal rating criteria to the criteria used by the external organisation and on a comparison of the internal and external ratings of any common obligors. Biases or inconsistencies in the mapping approach or underlying data must be avoided. The external organisation's criteria underlying the data used for quantification must be oriented to default risk only and not reflect transaction characteristics. The firm's analysis must include a comparison of the default definitions used, subject to the requirements in BIPRU 4.3.56 R to BIPRU 4.3.71 R and BIPRU 4.4.22 R (Definition of default). The firm must document the basis for the mapping.

[Note:BCD Annex VII Part 4 point 64]

To the extent that a firm uses statistical default prediction models it may estimate PDs as the simple average of default-probability estimates for individual obligors in a given grade. The firm's use of default probability models for this purpose must meet the standards specified in BIPRU 4.3.51 R.

[Note:BCD Annex VII Part 4 point 65]

Irrespective of whether a firm is using external, internal, or pooled data sources, or a combination of the three, for its PD estimation, the length of the underlying historical observation period used must be at least five years for at least one source. If the available observation period spans a longer period for any source, and this data is relevant, this longer period must be used. A firm not permitted to use own estimates of LGDs or conversion factors may have, when it implements the IRB approach, relevant data covering a period of two years. The period to be covered must increase by one year each year until relevant data cover a period of five years.

[Note:BCD Annex VII Part 4 point 66 (part)]

BIPRU 4.4.33 R - BIPRU 4.4.39 R set out requirements specific to the foundation IRB approach.

Under the foundation IRB approach a firm must apply the LGD values set out in BIPRU 4.4.34 R and BIPRU 4.8.25 R and the conversion factors set out in BIPRU 4.4.37 R.

[Note:BCD Article 87(8)]

A firm must use the following LGD values:

1. (1)

   senior exposures without eligible collateral, 45%;

2. (2)

   subordinated exposures without eligible collateral, 75%;

3. (3)

   a firm may recognise funded and unfunded credit protection in the LGD in accordance with BIPRU 5 (Credit risk mitigation), as modified by BIPRU 4.10;

4. (4)

   covered bonds may be assigned an LGD value of 12.5%; and

5. (5)

   for certain senior corporate exposure purchased receivables, for certain subordinated corporate exposure purchased receivables and for dilution risk of corporate purchased receivables the provisions of BIPRU 4.8.25 R (LGDs for corporate receivables) apply.

[Note:BCD Annex VII Part 2 point 8 (part)]

Until 31 December 2010, covered bonds as set out in BIPRU 3.4.107 R to BIPRU 3.4.110 R may be assigned an LGD value of 11.25% if:

1. (1)

   assets as set out in BIPRU 3.4.107 R (1)(a) to (c) collateralising the covered bonds all qualify for credit quality assessment step one3 as set out in BIPRU 3;

2. (2)

   where assets set out in BIPRU 3.4.107 R (1)(d) and BIPRU 3.4.107 R (1)(e) are used as collateral, the respective upper limits laid down in each of those points is 10% of the nominal amount of the outstanding issue;

3. (3)

   assets as set out in BIPRU 3.4.107 R (1)(f) are not used as collateral; or

4. (4)

   the covered bonds are the subject of a credit assessment by a nominated ECAI, and the ECAI places them in the most favourable category of credit assessment that the ECAI could make in respect of covered bonds.

[Note:BCD Annex VII Part 2 point 8 (part)]

BIPRU 4.4.37 R - BIPRU 4.4.39 R apply in addition to BIPRU 4.4.71 R - BIPRU 4.4.78 R.

1. (1)

   The exposure value for the items set out in this rule must be calculated as the committed but undrawn amount multiplied by the applicable conversion factor set out in this rule.

2. (2)

   For credit lines which are uncommitted, that are unconditionally cancellable at any time by the firm without prior notice, or that effectively provide for automatic cancellation due to deterioration in a borrower's credit worthiness, a conversion factor of 0 % applies. To apply a conversion factor of 0% a firm must actively monitor the financial condition of the obligor, and its internal control systems must enable it immediately to detect a deterioration in the credit quality of the obligor.

3. (3)

   For short-term letters of credit arising from the movement of goods, a conversion factor of 20% applies for both the issuing and confirming firms.

4. (4)

   For other credit lines, note issuance facilities (NIFs), and revolving underwriting facilities (RUFs), a conversion factor of 75% applies.

5. (5)

   For undrawn purchase commitments for revolving purchased receivables falling under BIPRU 4.8.29 R, the conversion factor set out in that rule applies.

[Note:BCD Annex VII Part 3 point 9 (part)]

Where a commitment refers to the extension of another commitment, the lower of the two conversion factors associated with the individual commitment must be used.

[Note:BCD Annex VII Part 3 point 10]

For all off-balance sheet items other than mentioned in BIPRU 4.4.37 R, BIPRU 4.4.45 R, BIPRU 4.4.71 R - BIPRU 4.4.78 R, BIPRU 4.6.44 R, BIPRU 4.8.28 R and BIPRU 4.8.29 R, the exposure value must be the following percentage of its value:

1. (1)

   100% if it is a full risk item;

2. (2)

   50% if it is a medium risk item;

3. (3)

   20% if it is a medium/low risk item; and

4. (4)

   0% if it is a low risk item.

For the purposes of this rule the off-balance sheet items must be assigned to risk categories as indicated in BIPRU 3.7 (Classification of off-balance sheet items).

[Note:BCD Annex VII Part 3 point 11]

1 BIPRU 4.4.41 R - BIPRU 4.4.55 R set out requirements specific to the advanced IRB approach.

1Under the advanced IRB approach a firm must use its own estimates of LGDs and conversion factors in accordance with BIPRU 4.

[Note:BCD Article 87(9)]

1A firm using own LGD estimates under the advanced IRB approach may recognise unfunded credit protection by adjusting PDs subject to BIPRU 4.4.43 R.

[Note:BCD Annex VII Part 2 point 6]

1Notwithstanding BIPRU 4.4.34 R and BIPRU 4.8.25 R, if a firm'sIRB permission permits it to use own LGD estimates under the advanced IRB approach for exposures to which BIPRU 4 applies and permits it to use the approach in this rule, unfunded credit protection may be recognised by adjusting PD and/or LGD estimates subject to the minimum IRB standards. A firm must not assign guaranteed exposures an adjusted PD or LGD such that the adjusted risk weight would be lower than that of a comparable, direct exposure to the guarantor.

[Note:BCD Annex VII Part 2 point 10]

1If a firm uses its own estimates of conversion factors under the advanced IRB approach it must calculate the exposure value of off-balance sheet exposures calculated with the use of conversion factors by using its own estimates of conversion factors across different product types as mentioned in BIPRU 4.4.37 R and BIPRU 4.4.39 R (2) to BIPRU 4.4.39 R (4).

[Note:BCD Annex VII Part 3 point 9 (part)]

1 BIPRU 4.4.48 R - BIPRU 4.4.50 R are in addition to BIPRU 4.3.25 R - BIPRU 4.3.28 R and BIPRU 4.4.6 R - BIPRU 4.4.9 R.

1If a firm'sIRB permission provides for it to use the advanced IRB approach for the calculation of LGDs, its rating system must incorporate a distinct facility rating scale which exclusively reflects LGD related transaction characteristics.

[Note:BCD Annex VII Part 4 point 9]

1A facility grade means for the purpose of the advanced IRB approach a risk category within a rating system's facility scale to which exposures are assigned on the basis of a specified and distinct set of rating criteria from which own estimates of LGDs are derived. The grade definition must include both a description of how exposures are assigned to the grade and of the criteria used to distinguish the level of risk across grades.

[Note:BCD Annex VII Part 4 point 10]

1Significant concentrations within a single facility grade must be supported by convincing empirical evidence that the facility grade covers a reasonably narrow LGD band, respectively, and that the risk posed by all exposures in the grade falls within that band.

[Note:BCD Annex VII Part 4 point 11]

1For a firm permitted to use own estimates of LGDs or conversion factors under the advanced IRB approach, each exposure must be assigned to a facility grade as part of the credit approval process. This is in addition to the requirements in BIPRU 4.4.11 R - BIPRU 4.4.13 R.

[Note:BCD Annex VII Part 4 point 20]

1As well as complying with BIPRU 4.3.54 R and BIPRU 4.4.21 R (Data maintenance), a firm using own estimates of LGDs and/or conversion factors under the advanced IRB approach must collect and store:

1. (1)

   complete histories of data on the facility ratings and LGD and conversion factor estimates associated with each rating scale3;

2. (2)

   the dates the ratings were assigned and the estimates were done;

3. (3)

   the key data and methodology used to derive the facility ratings and LGD and conversion factor estimates;

4. (4)

   the person who assigned the facility rating and the person who provided LGD and conversion factor estimates;

5. (5)

   data on the estimated and realised LGDs and conversion factors associated with each defaultedexposure;

6. (6)

   data on the LGD of the exposure before and after evaluation of the effects of a guarantee or credit derivative, for a firm that reflects the credit risk mitigating effects of guarantees or credit derivatives through LGD; and

7. (7)

   data on the components of loss for each defaultedexposure.

[Note:BCD Annex VII Part 4 Point 38]