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Rating Systems and Pools of Homogeneous Exposures in Retail and SME Banking
Company: Sofinco Group
Year Of Publication: 2007
Month Of Publication: January
Pages: 12
Download Count: 488
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Comment Num: 0
Language: EN
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Who Can Read: Free
Date: 1-15-2007
Publisher: Administrator
Summary
Basel II requires banks’ internal rating system to be sufficiently homogeneous and able ofproviding for meaningful differentiation of risk. While Basel II puts great emphasis on the necessary qualityof the underlying rating tools like scoring models, it says much less on how exposures must be groupedtogether into supposedly homogeneous pools. As a consequence, banks may find themselves under conflictingdemands. Indeed, on one hand, only a limited number of pools are manageable in terms of day-to-day riskmanagement and in order to respect a sound internal use. On the other hand, a limited number of pools maysuggest that the rating system is insufficiently homogeneous and should be refined towards better granularity.In this paper, we investigate the link between rating system design and homogeneity/discriminatory power.We first show that IRB formulas are naturally designed to provide banks with the right incentives to buildthe most granular rating system. Indeed, IRB formulas are concave with respect to PDs in most cases, butquite oddly, not for some range of PDs of Other Retail IRB formulas. Finally, we propose an Entropy-basedmeasure of homogeneity/discrimination which can be used as a sort of (pseudo-) risk weighted asset measureand whose value reads as a direct statistical test of whether a rating system is sufficiently granular
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Frachot, Antoine Sign in to follow this author
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