The internal ratings approach is geared toward basing a capital charge on the ratings that banks themselves assign to the credits in their portfolios. Full portfolio credit risk modeling goes a step further, using the internal risk ratings as a starting point and then applying sophisticated modeling techniques to adjust the ratings for portfolio effects to arrive at a capital charge for the entire portfolio. Advances are being made in both of these methodologies by many institutions. However, there are still a number of difficulties to work out before either of these approaches can be reliably used. Two major challenges posed by the internal risk ratings approach are the lack of consistency among the internal ratings systems, and the need to map internal ratings to a uniform schedule of capital charges.
Systems developed by individual banks can differ in a number of very important ways.
For example, some institutions may define the credit risk attributable to default as the probability that a loan will go bad, while others may go further and derive a loss figure that would result if the credit becomes a problem, the so-called loss given default. These inconsistencies compound the problem of translating internal ratings into a generally applicable range of risk weightings. Of course, moral hazard must also be considered in connection with any methodology that attaches significant economic consequences to a bank s own classification of its risks. Despite the issues raised by the internal ratings approach, it is still far closer to implementation than portfolio credit risk modeling, where challenges are much more difficult to overcome. As I noted, this approach has promise, but we are still a number of years away from being able to depend comfortably on credit risk models.