Basel II Use Test

Use-test is a potentially the widest and biggest area in Basel as it applies to all the portfolios and rating system within a bank. Also rating system in Basel not only implies the PD models but every elements which contribute to the internal ratings such as LGD, EAD, rating process, data, IT infrastructure, etc.

More over the page.

Use-test can be divided into the following areas:

1. Time and consistency (Basel II paragraphs 264, 444, 445)
Objective: To ensure the rating system was broadly in line for at least three years prior to qualification.
Scope: Bank should have documentation to identify all the histories and changes to the rating system since implementation. Changes may include new front end interfaces of inputting data, new controls, new version of the existing datawarehouse, model amendments, re-calibration, etc. Changes need to be clearly identified and documented to assist the local supervisor in evaluating whether they comply with the requirements.
2. Model Usage: “Use Test” (Basel II paragraphs 389)
Objective: Ensure the rating system is in day to day use for internal risk management as well as for capital calculation purposes.
Scope: Bank should have internal documentation such as model guidelines and policies to identify internal usage of the rating systems and their controls. The details should be clearly documented in order to assess that the usage of the rating systems is consistent with the IRB requirements.
3. Judgemental decisioning (Basel II paragraphs 417)
Objective: Ensure human oversight plays a role in the credit assessment process and appropriate controls are in place where judgement decisioning is involved.
Scope: Bank to implement controls relating to the credit assessment. Bank should have a regular audit on a sample of loan files to ensure these controls are properly in place. Ensure the judgemental decisions made are well documented and complies with the bank’s policies and should be comprehensively documented to satisfy the IRB requirements.
4. Data use and data quality (Basel II paragraphs 417)
Objective: Ensure the processes for inputting data into the rating system are accurate, complete and appropriate.
Scope: Bank should have a process to controls the data vetting process. Bank should have adequate documentation on the data input process, internal audit process to validate the accuracy of internal and external data for the calculation of the internal ratings.
5. Override (Basel II paragraphs 428)
Objective: Banks must clearly articulate the situations and processes for overriding any rating outputs. Ensure overrides are performed according to the policies.
Scope: Bank should have controls for rating overrides. There must be a process for internal audit for override cases and relevant policy on overrides. Performance of override must also be monitored and tracked on a regularly basis. Performance should include operational statistic as well as the credit performance of these overrides.
6. Rating completeness (Basel II paragraphs 422, 423)
Objective: Ensure all credit risk related legal entities (including guarantors) are rated as part of the loan approval process.
Scope: Ratings information for any obligors or guarantors should be readily available upon extraction of the Basel system.
7. Rating maintenance (Basel II paragraphs 425, 426, 427)
Objective: Ensure the ratings are refreshed as expected based on the bank’s policies but at least on an annual basis. Ensure the bank is able to obtain updated information from their borrowers as part of the rating review and the rating reviews are updated on a timely fashion. Rating update on a timely fashion means when new material risk information comes to light an immediate rating change within a review cycle should be performed.
Scope: Bank should have policies and documentations on rating update i.e. at least annual basis, high risk borrowers should be reviewed more regularly, type of new information that would trigger a review, controls to ensure review is being updated as required, etc. These rating refreshed should be done on a timely basis by the bank in order to satisfy the requirements.
Please feel free to add onto the list if I have missed out anything in particularly. I do hope anyone reading this could share their experiences in regards to the use-test. For example, the scope of the use-test, supervisory expectations, extent of the use-test, etc.