hard-wiring of external ratings in laws and regulations, including capital requirements.<sup>39</sup> The major constraint to the implementation of this measure is the limited internal risk management capacity of banks and the lack of alternative to external ratings. For many developing countries, this is exactly the constraint the majority of the banks are facing. Some countries (such as Brazil) have avoided the use of external credit ratings by adopting the simplified standardized approach (combined with the IRB approach for large banks), due to limited availability of external credit ratings or concerns about the quality of ratings. However, not all countries maintain the same views on credit ratings. There are economies of scale in the rating business and a benefit of specialization. In countries that continue to rely on external ratings in regulation, other measures to improve the incentive structure and oversight of the rating agencies and increase competition in the rating market warrant consideration.<sup>40</sup> Under the IRB approach of Basel II, banks are required to use long-term average of one-year probability of default (PD) and downturn loss given default (LGD), which should help mitigate procyclicality. However, banks‘ internal risk models often tend to focus on point-in-time estimates of PDs that vary through the cycle (due to reasons to be explained later in this section). These estimates then become inputs to the capital requirement calculation, making the latter procyclical. This tendency may have also revealed issues concerning supervisory validation of internal models due to data gaps and lenient interpretation of the Basel II requirements.

In order to mitigate the procyclicality of the minimum requirements, some regulatory bodies have proposed different approaches to adjusting banks‘ point-in-time PD estimates. The Committee of European Banking Supervisors (CEBS) proposed a Pillar 2 approach to adjusting for the compression of PD estimates during good times using downturn PDs.<sup>41</sup> The Financial Services Authority (FSA) of the United Kingdom, whose proposal predated the crisis, used a socalled variable scalar approach to converting point-in-time estimates to through-the-cycle PDs in order to smooth out the Pillar 1 minimum requirement.<sup>42</sup> This approach has been adopted by some UK banks for certain types of portfolios.

Conceptually these adjustments sound straightforward, but some practical challenges need to be considered in implementation.<sup>43</sup> First, there is a widespread lack of long time series of historical data, even in developed markets. Second, the choice of economic and credit cycle affects longrun estimates. Third, adding to the previous point, market structure and business practice evolve

> 39 See FSB (2010).

> 40 For a discussion of various measures on credit rating agencies, see European Commission (2010).

> 41 The CEBS proposal is devised in the context of stress testing under Pillar 2, but the methodology is linked to inputs for Pillar 1 minimum requirement and may be employed in Pillar 1 too. The adjustment can be thought of as an adjustment to the minimum requirement or a bank-specific countercyclical capital buffer (which is its initial intention). Due to its close link to the inputs in the minimum requirement, it is discussed in this section to distinguish it from the countercyclical capital buffer proposed by the Basel Committee to be discussed in the next section. See CEBS (2009) for details on the proposal.

> 42 See FSA (2006).

> 43 For discussions about practical difficulties related to the variable scalar approach to estimating through-the-cycle PDs, see FSA (2007) and FSA (2009b).

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