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Credit Risk

The dedicated space to converse with peers and our experts on all aspects of credit risk, from the technicalities of modelling using internal approaches, credit decisioning and underwriting, credit risk appetite, governance and monitoring, provisioning, and regulatory requirements

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  • Our dedicated space to discuss practicalities and technicalities of credit risk modelling using internal modelling approaches

    5 Topics
    14 Posts
    U

    In recent years, UK banks have increasingly found themselves allocating a significant portion of their risk budgets to Internal Ratings-Based (IRB) remediation programmes. This trend underscores a pervasive underestimation of the challenges involved in building and operating effective IRB models. As we look ahead, it is clear that a more effective approach is not only possible but essential for navigating the upcoming waves of regulatory scrutiny and operational demands

    Our experience - as well as regulatory feedback - shows that robust governance and senior ownership is important, reflected in committee membership and a culture of review and challenge of key judgments

    One critical issue is the composition of the teams tasked with model development. While these teams often possess substantial IRB expertise, they frequently lack robust coding skills. Although banks have established enablement and engineering teams to bridge this gap, the collaboration between these groups is often not fully functional. As a result, much of the code remains monolithic and SAS-based, which complicates quick implementation and increases the likelihood of errors. This disconnect highlights the need for a more integrated approach that combines modelling acumen with technical proficiency to enhance the efficiency and accuracy of IRB model development

    To address these pain points effectively, we recommend three key strategies. First, creating mixed teams of modellers and experienced coders can significantly enhance the development process. By integrating technical expertise with modelling knowledge, banks can improve workflow efficiencies. This collaborative approach not only streamlines the development timeline but also ensures that the initial code is closer to a deployable state. We have also found firms benefit from code sharing through platforms like GitHub, and establishing rigorous code review processes. Code libraries and ‘scaffolding’ (re-usable code structures) also make model development more controlled, repeatable and efficient.

    Second, when using external support, implementing risk-sharing arrangements for delivery can lead to more successful and cost-effective outcomes. By fixing delivery costs while also aligning incentives for successful model results, banks can attract the right level of seniority and mix of resources necessary for effective model development. This shift in focus can help mitigate the risks associated with failed deliveries, ultimately leading to better resource allocation

    Lastly, fostering greater involvement of internal stakeholders throughout the model development phase is crucial. By explicitly engaging these stakeholders and focusing on their understanding of risk management practices and the operational environment, banks can ensure that modelled approaches are more closely aligned with business needs. Additionally, enhancing the education of business units about IRB processes can facilitate stronger collaboration and reduce tensions between modelling teams and business units, ultimately improving the overall effectiveness of IRB models

    In conclusion, while the journey towards effective IRB remediation is challenging, there is a clear path forward. By addressing the pain points head-on and adopting a more integrated and collaborative approach, UK banks can not only ease the current IRB pain but also develop sustainable modelling capabilities going forward. If you would like to get more information on how we organise our teams in our risk-sharing agreements on IRB delivery, feel free to reach out

    This post was authored by Cem Dedeaga, a partner in our Finance and Risk Practice, based in the London office, specialising in prudential credit risk topics. With extensive experience across a diverse range of financial institutions, Cem leads large-scale prudential credit analytics delivery (IRB, IFRS 9) in the UK and Europe. His expertise encompasses the delivery of comprehensive credit risk models and frameworks, helping banks improve compliance with regulatory standards

  • Seasoning effects in IRB model development

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    0 Votes
    2 Posts
    16 Views
    J

    Hi there,

    Based on previous experience, for PD this is often not relevant: PDs are 12-month and the seasoning tends to be generally captured by the scoring model itself. A qualitative explanation of each scoring model and which characteristics it is considering that relate to seasoning may be enough, especially if complemented with quantitative analyses on the seasoning effect.

    For a more quantitative approach, suggest testing time since origination and time until maturity as potential risk drivers using the general risk driver assessment framework during PD calibration - in the past I've observed this not to be significant but again, this is anecdotal evidence.

    On LGD it may be relevant. However it should be understood that seasoning actually correlates with other significant risk drivers, particularly LTV and outstanding exposure amount. Here a deeper analysis of these parameters' significance should help "paint the broader picture".

    Regards

  • PD Calibration - Applying Bayes theorem

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    2 Posts
    16 Views
    J

    A couple of thoughts on this subject, from one of our experts:

    The discrepancy is caused by the adjustment implicitly assuming that a Bank would have had more defaults and lower scores (and so a worse average score) – while applying the theorem to a population which still has the same set of defaulted cases. This means the average scores are not worse, and hence you predicted PD will be lower.

    There are at least two approaches to deal with this effect:

    Adjust the constant term in the logistic until it hits the 2% target Run a “goal seek analysis" so that the average PD after mapping scores to the Bank grades, and applying the appropriate post-rating adjustments so the PD reaches 2%

    Especially for European banks IRB models are actually required to be quite conservative unless Banks have "perfect" data, so the long-run average can become a moot point to a certain extent

    On the topic of perfect data: if the Bank has enough data and the PD model is really powerful, it should find that there is no straight-line relationship between PD from logistic model vs. observed default rate. This is actually caused by the fact that whilst the errors are broadly normally distributed in logOdds space, when the distribution is converted to PD/default rate space the expectation will be closer to the mean than the original prediction.

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