Rating system philosophy

3.1 The term ‘rating philosophy’ describes the point at which a rating system sits on the spectrum between the stylised extremes of:

a. Point in Time (PiT): in which firms seek to explicitly estimate default risk over a fixed period, typically one year. A consequence of the use of such an approach is that the increase in default risk in a downturn results in a general tendency for migration to lower grades. When combined with the fixed estimate of the long-run default rate for the grade, the result is a higher IRB capital requirement; and

b. Through The Cycle (TTC): in which firms seek to take cyclical volatility out of the estimation of default risk, by assessing a borrower’s performance across the business cycle. Such ratings do not therefore react to changes in the cycle when it occurs, so there is no consequent volatility in capital requirements.

Variable scalar approaches

3.2 As a generalisation, variable scalar approaches transform the outputs of relatively PiT PD models into final estimates for IRB purposes that are based on portfolio-level long-run average default rates, with the consequence that they reduce/eliminate the cyclicality of the regulatory capital requirements in respect of PD.