The Presidents/Chief Executives
All Banks/DFls

Dear Sirs/ Madam,

Guidelines on Internal Credit Risk Rating Systems in Banks/DFIs

Proper identification and measurement of risk are prerequisites for an effective risk management. As the credit risk is the primary financial risk in the banking system, it should be efficiently and properly identified and measured, at all individual exposure levels. The assessment of the ability of each counterparty to fulfill its credit obligations is pre-requisite for building a robust credit risk management mechanism in every financial institution. This evaluation process is generally carried out through a credit risk rating/scoring mechanism. The importance of such mechanism necessitates that all financial institutions should have carefully designed risk rating systems to strengthen their overall risk management framework.

2. Keeping in view the importance of internal risk rating systems in the credit risk management and to further strengthen the risk management functions in banks/DFIs, State Bank has prepared guidelines on Internal Risk Rating Systems which are attached.
These guidelines will supplement the Guidelines on Risk Management already issued vide BSD Circular No. 07 dated August 15, 2003.

3. Banks/DFIs are free to adopt any of the rating systems/methodologies/techniques keeping in view their size, complexity of operations and clientele base and may have as many credit grades as they wish. However, for reporting purpose to the State Bank, banks are required to map their ratings to the SBP grades defined in the Annexure A of the guidelines. The mapping should be based on the given definitions and the bank’s internal definitions of the credit ratings.

4. All banks and DFIs are required to develop their internal credit risk rating policy duly approved by their Board of Directors and formulate a robust risk rating framework. Such developed policy may be made part of their credit risk or risk management policy. The policy covering Obligor Ratings, as mentioned in Section 3.2(2) of the attached guidelines, must be developed and all exposures must be rated in the light of such developed policy latest by June 30, 2008.

5. A copy of the policy should be sent to Banking Surveillance Department, State Bank of Pakistan latest by 30th June 2008. Banks/DFIs are further advised to map their internal risk ratings grades to the grades provided by the State Bank and report these mapped ratings in their regular eCIB reporting in the field IBRATING from the month of July 2008.

6. All Banks/DFIs are encouraged to establish their systems for carrying out Facility Ratings as mentioned in Section 3.2 (2) as soon as possible. They are further advised to submit a plan, latest by 31st March 2008, mentioning therein the detail of the identified activities with timelines for establishing the system for Facility Ratings.

7. Eventually all the banks will be required to further strengthen their internal risk rating systems as per the detailed requirements issued for the Internal Rating Based (IRB) approaches of Basel II.

Please acknowledge receipt.

Encl: Guidelines