The Presidents/Chief Executive Officers
All Banks/DFIs

Dear Sirs/ Madam,

Internal Credit Risk Rating System – Retail Portfolio

Please refer to BSD Circular No. 08 of October 29, 2007 regarding Guidelines on Internal Credit Risk Rating Systems in banks/DFIs.

1. It is clarified that the two dimensional rating requirement is applicable on corporate/ commercial/ SME portfolios. For retail loans (including retail SMEs) defined under Section 3.1.16 of BSD Circular No. 08 of 2006, banks and DFIs (hereinafter referred to as banks) may follow a single rating dimension. However, rating system for retail exposure should be oriented towards both borrower and transaction risk and must capture all the relevant borrower and transaction characteristics.

2. Banks shall develop an application and behavioral scorecards. Application scorecards measure the credit worthiness of a customer specifically at the application stage, based on the application/ credit initiation data. Whereas, behavioral scorecards measure the credit risk of a customer by monitoring the repayment behavior, changes in demographics and customer’s compliance with the loan covenants, etc. These are more particularly used in credit management/ monitoring decisions such as credit renewal/restriction, limit enhancement/ reduction, re-pricing, provisioning, etc. The banks should review and update the assigned scores at regular intervals, which may range from one month to a maximum of one year.

3. The selection of default drivers to be used for the scorecard development depends on power of these drivers towards predicting the default and as such these may vary from one portfolio to another. The selection of an appropriate model is at the banks’ discretion. A list of some of the default drivers that may be used for application and behavioral scorecards is annexed. However, these are suggestive default drivers and banks shall incorporate as many default drivers as they deem fit for their portfolio.

4. Banks should validate the predictive power of the default drivers and the model before putting the scorecard in use. Moreover, the predicted and actual defaults should be monitored on an ongoing basis and in case of significant deviation, scorecard should be validated. The banks should validate the scorecard on annual basis.

5. Banks need to analyze every retail loan using a set of default drivers and assign a specific score to each loan. Moreover, for advance approaches of credit risk under Basel II, the rating of retail portfolio is done on pooled basis. As such, banks shall assign each exposure that falls within the definition of retail for IRB purposes into a particular pool. Banks may use various attributes of the default drivers used in the application and behavioral scorecards as well as ranges of the assigned scores for segregating the portfolio into different pools. They must demonstrate that this process provides for a meaningful differentiation of risk, provides for a grouping of sufficiently homogenous exposures, and allows for accurate and consistent estimation of loss characteristics at pool level. Each obligor should be assigned a pool on the basis of its risk profile such that exposures sharing similar risk attributes should be assigned same pool. There must be a meaningful distribution of borrowers and exposures across pools and a single pool must not include an undue concentration of the banks’ total retail exposure.

6. While reporting in e-CIB, the banks are required to comply with the following points:

a. Application scores can generally be used up to six months after underwriting the loan and after that, the banks shall use behavioral scores.

b. Banks need to map the assigned scores to one of the twelve rating grades defined in BSD Circular No. 08 of 2007.

c. The rating corresponding to the highest risk (lowest rating) should be reported in the e-CIB in case the obligor has been assigned multiple ratings based on multiple exposures.

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