A process model to develop an internal rating system: sovereign credit ratings

Authors:
Tony Van Gestel;Bart Baesens;Peter Van Dijcke;Joao Garcia;Johan A. K. Suykens;Jan Vanthienen
Affiliations:
Credit Risk Modelling, Group Risk Management, Dexia Group, Square Meeus, Brussel, Belgium and K.U. Leuven, Department of Electrical Engineering, ESAT-SCD-SISTA, Leuven (Heverlee), Belgium;School of Management, University of Southampton, Southampton, UK;Research, Dexia Bank Belgium, Brussel, Belgium;Credit Risk Modelling, Group Risk Management, Dexia Group, Square Meeus, Brussel, Belgium;K.U. Leuven, Department of Electrical Engineering, ESAT-SCD-SISTA, Leuven (Heverlee), Belgium;K.U. Leuven, Department of Applied Economic Sciences, Leuven, Belgium
Venue:
Decision Support Systems
Year:
2006

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Abstract

The Basel II capital accord encourages financial institutions to develop rating systems for assessing the risk of default of their credit portfolios in order to better calculate the minimum regulatory capital needed to cover unexpected losses. In the internal ratings based approach, financial institutions are allowed to build their own models based on collected data. In this paper, a generic process model to develop an advanced internal rating system is presented in the context of country risk analysis of developed and developing countries. In the modelling step, a new, gradual approach is suggested to augment the well-known ordinal logistic regression model with a kernel based learning capability, hereby yielding models which are at the same time both accurate and readable. The estimated models are extensively evaluated and validated taking into account several criteria. Furthermore, it is shown how these models can be transformed into user-friendly and easy to understand scorecards.