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Unofficial translation

BOARD OF THE BANK OF LITHUANIA

RESOLUTIONNo140

of9 November 2006

on the regulations on validation and its ASSESSMENT

Vilnius

(Valstybės žinios (Official Gazette) No 142-5444, 2006)

Acting in observance of Article 9 Law of the Republic of Lithuania on the Bank of Lithuania (Valstybėsžinios (Official Gazette) No99-1957, 1994; No28-890, 2001) and in implementing Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions (recast) (OJ 2006 L 177, p.1), the Board of the Bank of Lithuania has r e s o l v e d:

1. To approve the Regulations on Validation and Its Assessment (attached).

2. To establish that the present Resolution comes into effect as from 1 January 2007.

Chairman of the BoardReinoldijus Šarkinas
APPROVED

by Resolution No140

of the Board

of the Bank of Lithuania

of 9 November 2006

REGULATIONS ON VALIDATION AND ITS ASSESSMENT

(Valstybės žinios (Official Gazette) No 142-5444, 2006)

CHAPTER I

GENERAL REGULATIONS

  1. Regulations on Validation and Its Assessment (hereinafter – the Regulations) shall apply to banks holding the license issued by the Bank of Lithuania and to the Central Credit Union, which for their capital adequacy calculation purposes apply the Internal ratings Based Approach (hereinafter – IRB approach) and (or) the operational risk Advanced Measurement Approach (hereinafter – AMA).
  2. The purpose of the present Regulations is to define the standards for validation of the IRB approach and AMA and for assessing such validation.
  3. The present Regulations have been developed in observance of Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions (recast) (OJ 2006 L 177, p.1) and on the basis of principles set forth in the following documents:
  4. Guidelines on the implementation, validation and assessment of Advanced Measurement (AMA) and Internal Ratings Based (IRB) Approaches issued by the Committee of European Banking Supervisors;
  5. Studies on the Validation of internal rating systems, Validation of low default portfolios in the Basel II framework and The treatment of expected losses by banks using the AMA under the Basel II framework issued by the Basel Committee on Banking Supervision;
  6. Internal ratings–based systems for corporate credit and operational risk advanced measurement approaches for regulatory capital issued by the Federal Deposit Insurance Corporation.
  7. Requirements of the present Regulation shall apply together with the requirements of the General Regulations for the Calculation of Capital Adequacy approved by Bank of Lithuania Board Resolution No. 138 of 9 November 2006 (Valstybės žinios (Official Gazette) No142-5442, 2006).

CHAPTER II

VALIDATION OF THE IRB APPROACH

  1. Terms used for the purpose of this Chapter:
  2. Validationencompasses the range of processes and activities aimed at assessing the credibility of the rating system structure and assignment of ratings, as well as of the quantification of risk parameters and processes.
  3. Back-testing means validation method that involves comparing of estimated risk parameters with respective realised values.
  4. Benchmarking means validation method that involves comparing internal ratings and estimated risk parameters with respective internal and external ratings and parameters obtained using other estimation techniques.
  5. Low-default portfolio means portfolio with more than one case of realised default event, or portfolio free from any cases of realised defaults.
  6. Risk parameters means quantitative outcomes of the rating system and quantification methods , i.e. probability of default (hereinafter – PD), loss given default (hereinafter – LGD), conversion factor (hereinafter – CF), expected loss (hereinafter – EL), etc.
  7. Obligor grade means a risk category within a rating system's obligor rating scale, to which obligors are assigned on the basis of a specified and distinct set of rating criteria and from which estimates of PD are derived.
  8. Facility grademeansa risk category within a rating system's facility rating scale, to which exposures are assigned on the basis of a specified and distinct set of rating standards and from which own estimates of LGDs and (or) CFs are derived.
  9. Assignment process means associating the obligor (exposure) with the respective grade of the rating scale of the borrower (exposure), or in case of retail exposures - with respective risk pools in accordance with the assignment criteria.
  10. Discriminatory (separation) power means ability of the rating system to distinguish potential defaulting borrowers from non-defaulting ones, or in case of retail exposures – to distinguish exposures which will be defaulted from those which will not be defaulted.
  11. Calibration means determining risk parameters for obligor or facility grades and risk pools.
  12. Quantification process involves collection of data, estimation of risk parameters, mapping such parameters to respective obligor or facility grades or risk pools and using them for the calculation of capital adequacy.
  13. Confidence level means range between two values of the measure being assessed to which the latter belongs under a certain probability.
  14. Through–the–cycle rating is assigned when the obligor or exposure risk is assessed relying on assumption of the existing economic downturn phase.
  15. Point–in–time rating is assigned when the obligor or exposure risk is assessed on the basis of current situation and existing phase of the economic cycle.
  16. Rating transition matrix shows changes in the bank’s rating system grades or risk pools of a given period, i.e. percentage of obligors (exposures) previously assigned to a particular grade or risk pool, which is presently transferred to any other grade or risk pool.
  17. Internal models method means method applied for the calculation of capital required for covering credit risk of equities.
  18. External vendor model means credit assessment model developed by third parties used for the bank's risk assessment and management purposes.
  19. Reference data set means data set used for the estimation of the respective risk parameter.

SECTION I

VALIDATION PROCESS

  1. The bank shall have in place the adequate validation process of its IRB approach, i.e. covering all elements listed in Annex 1 and contributing to consistent and meaningful validation of the internal rating systems and processes and to determining the conformity of these systems and processes with the requirements of the present Regulations and of Part II, Chapter IV of the General Regulations for the Calculation of Capital Adequacy. Requirements of the present Regulations shall apply to the extent of their appropriateness in each particular case, e.g., when the bank applies the slotting criteria approach to its specialised lending exposures, the quantitative validation of risk parameters shall not be required.
  2. The bank’s validation shall encompass qualitative elements (assessment of structure of the rating system, data quality, use of rating systems in other activities (i.e., not only for the capital adequacy calculation purposes, etc.) and quantitative elements (discriminatory power, accuracy of calibration , assessment of stability, etc.). The bank shall select the most appropriate validation methods on its own discretion. When quantitative validation performed is not reliable because of the insufficient amount of information, the bank shall pay more attention to the qualitative validation.
  3. Validation shall be an ongoing and regular process. Validation methods and data shall be used in consistent manner. The bank shall review on a regular basis its validation methods and data used in consideration of changes in market or operating conditions (e.g., upon change of the extent of data applied in assignment or quantification processes , duration of historical data observation periods, characteristics of exposures or obligors , crediting standards, etc.).
  4. The bank’s validation process and its outcomes shall be subject to review by the respective employees of the bank independent from staff in charge of the development and implementation of validation processes. An independent review may be carried out by one or more structural units. The Internal Audit Committee shall monitor the enforcement of the developed validation processes.
  5. The process of validation and all its elements (applied methods, their justification, used data, liability, accountability, independence, scope, documentation, regularity, outcomes and actions in consideration of obtained results), changes in such elements and their reasons shall be documented. The documentation shall be subject to regular reviews and amended where appropriate. The process of validation and all its elements shall be approved by a respective bank or bank group management body, structural unit or committee.
  6. The bank shall establish the general principles, what actions shall be taken on the basis of validation outcomes. The bank shall have in place reliable internal standards for such situations when deviations of realised risk parameters from forecasted quantitative risk parameters become quite significant. Where practicable, the bank shall with due regard to the specifics of the applicable quantitative validation methods establish the acceptable intervals of the results of methods used for determining the discriminatory power, accuracy of calibration and stability as well as of other quantitative validation methods, also providing for the respective actions when resulting values do not fall within this interval of acceptable estimates. The bank shall take into account the economic cycles and other volatility of risk parameters of systemic nature. The bank shall to the extent possible provide for the situations, when these intervals and respective actions may be changed.
  7. The Bank of Lithuania shall carry out regular reviews of the bank’s validation process and separate elements thereof (validation methods applied by the bank, their justification, used data, regularity, liability, accountability, independence, scope, documentation, outcomes and actions in consideration of obtained results), in order to assess whether the bank’s validation process is consistent with requirements of the present Regulations, the internal rating systems and processes used by the bank are reliable and in line with the requirements set forth under Part II, Chapter IV of the General Regulations for the Calculation of Capital Adequacy.

SECTION II

validation of rating systems

  1. For the purpose of validation or rating systems (and applicable methods) the bank shall observe the principles of objectivity, accuracy, stability, monotony, appropriateness, conservatism and consistency:
  2. in observance of the principle of objectivity, the bank shall guarantee that obligors (exposures) assigned to same obligor (facility) grade or risk pool have similar characteristics and level of risk. For the purpose of development of rating systems, assignment of obligors (exposures) to grades or risk pools and quantification processes, the bank shall take into account expert judgements, including the overrides. The bank shall consider how the expert judgement is applied in order to obtain objective outcomes of the rating system. When the bank relies exclusively upon expert judgement when assigning obligors or exposures to grades, the assignment standards shall be formulated in clear manner so as to avoid any interpretations thereof, and the bank shall have in place the assessment guide developed in appropriate manner;
  3. in observance of the principle of accuracy, the bank shall guarantee that the assessment of creditworthiness of the obligor (exposure) is accurate, quantified risk parameters conform to the respective realised parameters and input values are appropriate;
  4. in observance of the principle of stability, the bank shall guarantee that ratings and risk parameters will not change, when the underlying risk characteristics of obligors or exposures remain the same (excluding changes of ratings and risk parameters related with the developments of the economic cycle);
  5. in observance of the principle of monotony, the bank shall guarantee that lower-grade risk parameter values will be more conservative than the respective risk parameter values of the higher grade or risk group;
  6. in observance of the principle of appropriateness, the bank shall guarantee that all information relating to the obligor (exposure) will be assessed, e.g., whether the bank uses sufficient amount of assignment criteria for the purpose of assignment obligors to respective grades relying on expert judgements. The bank, which applies statistical models and, e.g., does not assess the measure of profitability, liquidity, turnover, debt servicing or any other significant criterion, shall have to prove that such criterion is insignificant;
  7. in observance of the principle of conservatism, the bank shall guarantee that ratings will be assigned in conservative manner, and risk parameters will be subject to the conservatism margin in observance of the expected range of estimation errors;
  8. in observance of the principle of consistency, the bank shall guarantee that rating systems and respective applicable methods are conceptually reasonable. For example, upon increase of ceteris paribus profitability, the obligor’s condition should not be considered as worsening.
  9. The bank applying several rating systems with different characteristics shall guarantee that such systems are applied in consistent manner and that it is well-aware of their differences, including the ability to match, where appropriate, the outcomes of different rating systems.

SECTION III

VALIDATION OF RATING SYSTEM STRUCTURE AND ASSIGNMENT PROCESS

  1. The bank shall carry out regular assessment of the rating system structure and the process of assignment of obligors or exposures to grades or risk pools, with a view to determining their consistency with the requirements set forth under Part II, Chapter IV of the General Regulations for the Calculation of Capital Adequacy.
  1. Assessment of the rating system structure
  1. The bank shall assess:
  2. whether in case of applying several rating systems to different obligor or exposure categories the assignment of obligors or exposures to the particular rating system is appropriate and whether such assignment criteria are appropriate and subject to regular review;
  3. whether the rating system covers a separate obligor rating scale (for exposure classes of central governments and central banks, institutions and corporates) and - where own estimates of LGD and (or) CF are used – the bank’s own facility rating scale;
  4. in consideration of characteristics of the respective exposure class or subclass, the adequacy of granularityper each rating scale, possible concentration of obligors or exposures in grades or risk pools, etc.;
  5. whether there’s sufficient number of obligors or exposures in each grade or risk pool for the quantification and validation of risk parameters;
  6. whether obligors or exposures with the same risk features are assigned to the same grades and risk pools;
  7. whether the rating system structure is in line with the requirements of Subsection 9.1.1, Part II, Chapter IV of the General Regulations for the Calculation of Capital Adequacy.
  1. Validation of assignment process
  1. The bank shall asses the validity of methods (expert judgements, models (statistical models, models derived by experts) and (or) hybrid methods) applied when assigning obligors or exposures to grades or risk pools.
  2. The bank shall carry out ex ante and ex post validation of methods used in the assignment process.
  3. The bank shall determine the appropriateness of the assignment criteria , for example, whether:
  4. the criteria are matched with the bank’s internal crediting standards and the bank’s policy when there are problem credits;
  5. the discriminatory power of the individual assignment criterion is adequate, i.e. whether in observance of such criterion defaulting obligors can be distinguished from the non-defaulting ones;
  6. the discriminatory power of the individual criterion has reduced and, if so, then what are the reasons for such reduction;
  7. the individual assignment criterion can be replaced by another criterion;
  8. the individual criterion or all criteria applicable in the process of assignment to grades or risk pools can be replaced by external data;
  9. there’re systemic changes of input parameters or assignment criteria , if so, what are such changes;
  10. the selected period is sufficient for the assessment of criteria.
  11. The bank shall assess whether the respective internal documents of the bank have been observed during the assignment process.
  12. The bank shall assess whether used definitions of the obligor (facility) grades and risk pools conform to the requirements provided for in Subsection 9.1.1, Part II, Chapter IV of the General Regulations for the Calculation of Capital Adequacy.
  13. The bank shall assess the information about the obligor (exposure) used in the assignment process, i.e. determine, whether the information about obligor (exposure) used in the process of assignment of obligors (exposures) to grades or risk pools satisfies the requirements of Subsection 9.1.1, Part II, Chapter IV of the General Regulations for the Calculation of Capital Adequacy.
  14. The bank which uses a statistical model for the purpose of assigning obligors (exposures) to grades or risk pools, shall:
  15. assess methodology used for the model development;
  16. determine whether data are comprehensive, of good quality, accurate, appropriate and representative;
  17. determine the appropriateness of input parameters. Where the bank uses regressive models for the purpose of determining the appropriateness of input parameters in developing such models, it shall assess the outliers, economic logic of input parameters and their statistical significance:
  18. to determine the economic logic of input parameters, the bank shall assess the validity of a plus or minus sign of the input parameter. For example, when developing the logistic regression credit assessment model, the bank uses profitability ratio as one of the input parameters, but in the created regressive equation the profitability ratio parameter has a plus sign, i.e., upon increase of the obligor’s profitability, the equation result (i.e., PD) would increase, which is incompatible with economic logic. In such case this parameter should be refused;
  19. to determine statistical significance of input parameters, the bank may apply different statistical values (t-values, F-values, etc.). Additionally, the bank shall assess the degree of multicolinearity of the input parameters, i.e. correlation between input parameters;
  20. carry out model testing with data excluded from data sample used for model development, i.e. use out-of-time and out-of-sample data.
  21. In case of hybrid models, the bank shall assess the significance of expert judgement in the assignment process. For example, the bank may compare default rates of categories of obligors which at the initial stage of the process of assignment to grades or risk pools had equal ratings, but after expert assessment received different ratings, with the respective PDs established for such categories.