Office of the Superintendent of Financial Institutions
This paper outlines and explains principles that institutionsFootnote 1 should apply to satisfy the “use test” requirements in Chapter 5 of
OSFI’s Capital Adequacy Requirements (CAR) Guideline A-1. Under
the internal ratings-based (IRB) methodology, institutions may calculate
minimum regulatory capital using their own estimates of loss from their
own internal ratings. However, the use test prohibits institutions from
using default and loss estimates that are developed for the sole purpose
of calculating regulatory capital. Institutions may only use rating
systems and loss estimates from these systems if they are used in other
operations of the institution.
Adherence to the above-noted principles will be an important consideration
in OSFI’s initial approval of institutions for IRB and ongoing use of the
In their normal operations, institutions develop internal ratings to
measure and manage risk. The assumption behind the IRB method is that if
ratings and estimates derived from these ratings play an important role in
their operation, institutions are likely to ensure that the ratings and
estimates derived from these ratings are accurate. Therefore, estimates
from these ratings systems can be used to calculate a regulatory capital
requirement that better reflects portfolio risks than do estimates
calculated on external ratings. Another reason for the development of the
IRB approach was to encourage institutions to improve their measurement
and management of risk.
Institutions may look to CAR for specific standards applicable to IRB.
This document sets out principles that IRB institutions should apply to
the use of ratings and estimates with some discussion and examples. They
are given with the understanding that they will be tempered with good
judgment. This understanding does not negate the principles, but may
restrain their application to avoid undue costs or perverse results. When
institutions encounter situations for which the examples given are not
appropriate, they should consider other ways to satisfy the principles.
Adherence to these principles will be an important consideration in OSFI’s
initial approval of institutions for IRB and ongoing use of the IRB
In discussion of the use test, “operations” should be interpreted as the
operations listed in the use test requirements of CAR; namely, the credit
approval, risk management, internal capital allocations, and corporate
governance functions of institutionsFootnote 2.
To make the use of the IRB approach credible, internal ratings and
estimates of default and loss should be entrenched in institution
operations and reporting, including reports to senior management and the
Board of Directors.
Most institutions rate risks to protect themselves from unprofitable
credit exposures. However, some are satisfied with excluding the worst
applicants for credit exposures and accepting the best, without attempting
to estimate absolute levels of loss. IRB institutions should not only rank
risks, they should also produce measures of risk that can be reliably
translated into the measures defined in CAR, especially the parameters PD,
EAD, LGDFootnote 3, and maturity.
Institutions may use internal ratings and loss estimates that are not used
to calculate IRB regulatory capital. However, the rating systems that are
used to generate the inputs to IRB capital calculations should have a use
with a material impact on institution operations. OSFI recognises that
this may be more challenging for certain exposure classes (e.g., retail
exposures); however, the underlying principle here is that the simple
existence of models and parameter estimates used solely for regulatory
capital purposes is not, in and of itself, sufficient for IRB approval
Institutions should interpret internal ratings and default and loss
An internal credit rating or estimate of credit losses should be
considered for the use test even if it does not match all the requirements
of CAR for internal ratings and default and loss estimates. For example,
an issuer of credit cards can claim that the scoring models it develops to
predict the probability of going “bad” is using default estimates even if
a “bad” account is not “defaulted” according to definitions contained
within CAR. Further, default and loss estimates may be implicit in models
that predict profitability.
A narrow interpretation of “internal ratings” and “estimates” would
require institutions to make radical and expensive changes to the
functions listed in CAR. Ratings and estimates developed specifically for
other purposes may do their intended jobs better than ratings and
estimates developed to IRB specifications. Risk management measures
specified entirely by IRB requirements would likely become outdated, as
CAR changes infrequently. In summary, a narrow interpretation would be
inconsistent with two chief advantages of the IRB approach: the
encouragement of institutions to develop their ability to manage risk, and
the increased sensitivity of capital to risk as institutions improve their
systems to measure risk.
Institutions should identify all uses of risk rating systems, especially
implicit or explicit measures of PD, LGD, EAD and maturity, that are
likely to have a material impact on institution operations.
Institutions cannot ensure consistency between estimates of PD, LGD and
EAD used throughout the institution with IRB risk inputs unless they know
what they are. Without the maintenance of an inventory, there is little
possibility that the institution can guard against the cherry picking of
This principle applies only to operations that are likely to have a
material impact. It does not touch calculations for which the impact of
credit losses is likely to be small, or that support recommendations that
are not yet adopted. Institutions should be careful to distinguish between
direct estimates of default and those parameters ‘backed out’ of models.
Institutions should maintain an inventory of models and estimates.
Appendix IV illustrates information that institutions should retain for
retail models. Different information would be useful for non-retail
Institutions should use estimates for IRB capital calculations that are
consistent with the estimates that institutions use for other purposes. In
deriving estimates for IRB capital, institutions should recognise risk
factors in other operations of risk management, unless these factors have
no material relevance.
As set out in CAR, institutions need not use the same estimates in all
their operations, but estimates should be consistent: one estimate should
be plausible given the other. For example, an estimate of PD over one year
used for IRB should generally be higher than the PD over six months, and
by a factor consistent with the institution’s view of the incidence of
defaults for aging exposures.
If the institution recognises a factor as relevant to the estimation or
management of credit losses in its operations, it should presume that
these factors are relevant to the calculation of IRB parameters, unless it
is clear that they are not. For example, if the institution’s calculation
of economic capital recognises that LGD varies by different classes of
collateral, these classes should play a role in the calculation of IRB
If two estimates used in operations are inconsistent with each other, it
may be impossible to arrive at IRB estimates consistent with both. While
the institution should aim to develop consistent estimates across its
operations, the institution may satisfy the consistency principle by
comparing its IRB estimates to the estimates that are most relevant,
taking into account:
Institutions should reconcile estimates used for IRB capital calculations
with other estimates in their inventories.
Reconciliation demonstrates consistency. However, the term
“reconciliation” is not to be confused with standards of reconciliation
applicable to other financial reporting. Rather, it refers to a reasonable
comparison of estimates. For example, an estimate of PD used for IRB
regulatory capital purposes should rarely match a PD estimate for the same
exposure that is used for pricing (if the defaults in question are defined
differently), if only one of the estimates is conditional on current
economic conditions, or the estimates are for defaults over different
Reconciliation is a requirement to demonstrate that differences in
estimates are reasonable. It also includes, when estimates match,
a demonstration that the use of matching estimates is appropriate, because
the same thing is estimated. Appendix III further discusses
A reconciliation of estimates may also recognise intended conservatism.
If there are material discrepancies between the estimates used for IRB and
the estimates for another use, the IRB capital requirements should
typically be higher than capital requirements when using other estimates.
Institutions should be no less cautious in the calculation of regulatory
capital than they are in their operations.
The comparison required by this principle should be done after the
reconciliation process has converted estimates for operations to a form
suitable to IRB, such as adjustments to account for variations in default
and loss definitions.
Institutions should only apply this principle to estimates that have a
material impact on their operations and where conservatism has a material
Where possible, institutions should develop default and loss estimates
affecting a line of business from a common database, using a common model.
The development of many different databases and models creates many
problems. These problems may include:
These problems may be alleviated through the creation of an integrated
database and a common model to serve different purposes. Further, an
integrated database offers evident advantages for the discovery and
validation of new explanatory variables.
There are often plausible reasons to retain distinct models for different
purposes. For example, institutions issuing retail business often have
different data available for origination than for ongoing account
management and the development of provisions. A complex model may also
take too much time to run for adjudication, but may be feasible for the
estimation of a parameter used in IRB. Whatever the reason for the use of
different models, institutions should consider whether the models tell the
same story. For example, the adjudication model might say that PD (or some
proxy) depends on a set of given variables. The model used to calculate
IRB PD might say that PD depends on another set of given variables. Both
models should give the same answer for an average portfolio PD.
If an institution has reason to believe that the risk of default is
reasonably constant through the tenor of a loan, it may reconcile PDt, to
PDs, defined over terms t and s, respectively, through the formula (1−PDt)^(1÷t)=(1−PDs)^(1÷s).
However, many loans exhibit strong seasoning effects. In this case,
reconciliation would need to take into account the variation of default
risk through time.
If one definition of default covers a different list of events than the
definition of default used for IRB estimates, the institution should study
the relative incidence of these events to justify the relationship between
resulting estimates of PD, LGD and EAD.
Institutions should verify that estimates of loss are consistent, and
verify differences. In particular, institutions should reconcile the
economic losses used for IRB estimates to accounting estimates and data.
If non-IRB estimates are analysed into PD, LGD and EAD, the product should
be reconciled to the product of PD, LGD, and EAD used for IRB after each
component has been suitably adjusted (e.g., for differing definitions or
terms) and reconciled individually. For some purposes, institutions may
report and estimate losses without an analysis into PD, LGD and EAD as
required for the calculation of IRB capital. Estimates of total loss to
the total losses implied by PD*EAD*LGD from IRB estimates should be
reconciled after other appropriate adjustments.
The institution should ensure a sensible relationship between current
default estimates, long-term estimates, and the current default experience
of other lenders in the same sector.
In their retail operations, institutions develop scores or other
indicators that are useful in predicting events that are highly correlated
with default as defined in CAR. For example, scores may predict the
probability of going "bad" over a horizon of 18 months. The scores are
often used in decisions to extend more credit, to reduce limits, or to
pursue full payment of outstanding loans. At acquisition these scores are
generally based on data from credit data agencies. Later, scores are
enriched with data from the institution's own files, especially records of
customers’ behaviour. As such, these scores are referred to as “behaviour
Principle 3 of this Note directs institutions to identify various measures
of risk used in the management of the institution, and Principle 5 calls
for a reconciliation. As drivers of ratings and measures of the odds of
default (not necessarily default as defined in CAR), behaviour and
acquisition scores should be identified and reviewed for consistency with
IRB estimates. However, the depth of this review should depend on the
relevance of the score to IRB estimates.
Institutions may be able to demonstrate that once behaviour scores are
available, acquisition scores are irrelevant to the management of accounts
and the prediction of risk: knowing acquisition scores in addition to
behaviour scores does not help predict defaultsFootnote 4. This is strong evidence
that acquisition scores do not affect the credibility of IRB estimates
once behaviour scores replace them in the management of accounts and other
functions sensitive to credit risk, such as the establishment of
provisions and the measurement of economic capital. With this evidence,
there is no need to reconcile acquisition scores to IRB estimates for any
business managed by behaviour scores, or to consider whether IRB
segmentation is as predictive as acquisition scores. It is sufficient to
compare IRB estimates to odds derived from behaviour scores and verify
that the major drivers of behaviour scores are recognized in IRB
Any institution that is originating transactions will have some business
for which there are only acquisition scores. If this is material, the
institution should compare the credit quality as predicted by acquisition
scores to IRB estimates of PD.
As outlined in Principle 5 of this Note, institutions should reconcile
different estimates of default to their IRB inputs. Because both IRB and
other estimates are subject to uncertainty, this reconciliation cannot be
precise. When two estimates are bound by tight confidence intervals, apply
to the same population, and differ only in one well-defined aspect (such
as days’ delinquency to default), a close reconciliation should be
possible. In other circumstances it may be possible only to demonstrate
that the difference between the estimates is in the right direction.
The first step in this reconciliation is to determine what estimates are
relevant and the degree of precision in these estimates. Generally, an
estimate is relevant to an IRB estimate if it is applied to the same
The next step in this reconciliation is to identify how the development of
the estimates differed in ways that might affect measures of risk. Some
measures to consider are:
Institutions will think of other relevant factors. After identifying the
differences in the development of the estimates, institutions should
calculate the most likely effect of each difference, as well as a possible
range. Finally, institutions should consider whether the aggregated
differences could bring one estimate within the confidence interval
surrounding the other.
The institution should determine how to aggregate the individual effects
and arrive at a reasonable range of possibilities. It would then compare
the behaviour score, adjusted for the aggregate effects of the
differences, to the IRB PD, calculated before adjustment, to arrive at a
long-term average and the addition of margins for conservatism. The
institution would then decide whether the estimates are consistent. At
best, given the many differences between the estimates, the institution
might be able to decide that the aggregate probability of going bad
predicted by the behaviour, could plausibly fall between 1.10 and 1.90
times the aggregate IRB for the same population, before adjustment to
arrive at a long-term average and addition of margins of conservatism.
Principle 4 outlines that institutions should maintain clear and
comprehensive documentation regarding the objectives, scope and design of
the rating systems. For retail exposures of retail risk rating systems
where there could be multiple risk rating models, the following sample
inventory listing could be used to summarize the rating system design and
relevance of the models.
Retail Model Inventory Table (Text Version)
Banks and bank holding companies to which the Bank Act applies
and federally regulated trust or loan companies to which the Trust and
Loan Companies Act applies are collectively referred to as
Return to footnote 1 referrer
Appendix I provides examples of the use test principles.
Return to footnote 2 referrer
“PD” – probability of default; “EAD” – exposure at default; “LGD” – loss
Return to footnote 3 referrer
After an account is booked or a banking relationship has been
established, an acquisition score, or credit information underlying the
acquisition score, may be a component of a behaviour score.
Return to footnote 4 referrer