12.A1 When applying the CRR requirements relating to the estimation of the probability of default, the PRA expects firms to comply with the EBA’s Guidelines on PD estimation, LGD estimation and the treatment of defaulted assets (EBA/GL/2017/16).

Rating philosophy

12.1 ‘Rating philosophy’ describes the point at which a rating system sits on the spectrum between the stylised extremes of a point in time (PiT) rating system and a through the cycle (TTC) rating system. Points (a) and (b) explain these concepts further:

(a) PiT: firms seek explicitly to estimate default risk over a fixed period, typically one year. Under such an approach 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 capital requirement. Where data are sufficient, grade level default rates tend to be stable and relatively close to the PD estimates; and

(b) TTC: firms seek to remove cyclical volatility from the estimation of default risk, by assessing borrowers’ performance across the economic cycle. TTC ratings do not react to changes in the cycle, so there is no consequent volatility in capital requirements. Actual default rates in each grade diverge from the PD estimate for the grade, with actual default rates relatively higher at weak points in the cycle and relatively lower at strong points.