2012 Registration document and annual financial report - BNP Paribas

5RISKSAND CAPITAL ADEQUACYCredit risk5Various quantitative and other methods are used to check ratingconsistency and the rating system’s robustness. Loans to privatecustomers and very small businesses are rated using statistical analysesof groups of risks with the same characteristics. GRM has overallresponsibility for the quality of the entire system. This responsibility isfulfilled by either defining the system directly, validating it or verifyingits performance. The teams responsible for verifying performance arenot the same as those who build the models. At BNP Paribas, a specialSteering Centre has been set up for this purpose.Loss Given Default is determined either using statistical models for bookswith the highest degree of granularity or using expert judgment basedon indicative values, in line with a process similar to the one used todetermine the counterparty rating for corporate books (1) . Loss GivenDefault is defined as the loss that the Bank would suffer in the event ofthe counterparty’s default in times of economic slowdown, as requiredby regulations.For each transaction, it is measured using the recovery rate for a seniorunsecured exposure to the counterparty concerned, adjusted for anyeffects related to the transaction structure (e.g. subordination) and for theeffects of any risk mitigation techniques (collateral and other security).Amounts recoverable against collateral and other security are estimatedeach year on a conservative basis and hair cuts are applied for realisingsecurity in a stressed environment.Various Credit Conversion Factors have been modelled by the Bank wherepermitted (i.e. excluding high-risk transactions where the conversionfactor is 100% and provided there was a detailed enough track record tobe statistically exploitable), either using historical internal default dataor other techniques when there is insufficient historical data. Conversionfactors are used to measure the off-balance sheet exposure at risk in theevent of borrower default. Unlike rating and recovery rate, this parameteris assigned automatically depending on the transaction type and is notdetermined by the Credit Committee.Each of the three credit risk parameters are backtested and probabilityof default benchmarked annually to check the system’s performance foreach of the Bank’s business segments. Backtesting consists of comparingestimated and actual results for each parameter. Benchmarking consistsof comparing the parameters estimated internally with those of externalorganisations.For the Corporate IRBA scope, all ratings, including default ratings 11 and12, for all counterparties to which the Bank has a credit risk exposure,have been recorded in a database since 2002. Likewise, Global RecoveryRates on defaulting exposures at a given time during the period arealso archived. Backtesting is performed on the basis of this informationfor each of the risk inputs, both globally and across the scope of eachrating method. These exercises aim to measure overall performance andthe performance of each rating method, and in particular, to verify themodel’s discriminatory power (i.e. the less well rated counterpartiesought to default more often than the better rated ones) as well as thepredictive, conservative nature of the inputs. For this purpose, actualGlobal Recovery Rates (GRR) and default rates are compared withestimated Global Recovery Rates and default rates for each rating.The “through the cycle” or “downturn” nature of the ratings and GRRsrespectively are also verified.This backtesting work revealed that actual default rates on IRBAcorporate scope are significantly lower than estimated default ratesacross the entire cycle (average annual default rate of 1.03% between2001 and 2011 compared with an estimated rate of 1.82%). An analysisof default rates during crisis periods shows that annual default ratesare always lower than estimated rates.Performance measurements are also carried out on sub-scopesof homogeneous asset classes. If the predictive power of a modeldeteriorates, it is recalibrated or redeveloped as appropriate. Thesechanges are submitted to the regulator for approval in line with theregulations.For benchmarking work on non- retail exposures, internal ratings arecompared with the external ratings of several agencies based on themapping between internal and external rating scales. Some 10% to15% of the Group’s corporate clients have an external rating and thebenchmarking studies reveal a conservative approach to internal ratings.Backtesting of Global Recovery Rates is based mainly on analysingrecovery flows on exposures in default. When an exposure has beenwritten off, each amount recovered is discounted back to the defaultdate and calculated as a percentage of the exposure. When an exposurehas not yet been written off, the amount of provisions taken is usedas a proxy for future recoveries. The recovery rate determined in thisway is then compared with the initially forecasted rate one year beforedefault occurred. As with ratings, recovery rates are analysed on anoverall basis and by rating policy and geographical area. Variances onan item by item and average basis are analysed taking into account thebimodal distribution of recovery rates. The results of these tests showthat the Group’s estimates are relevant in economic downturns and areconservative on an average basis. Benchmarking of recovery rates isbased on data pooling initiatives in which the Group takes part.The result of all backtesting and benchmarking work is presentedannually to the Chief Risk Officer and the Bank’s governing bodies. Theseresults and ensuing discussions are used to help set priorities in terms ofdeveloping methodology and deploying tools. Backtesting is also certifiedinternally by an independent team and the results sent to the ACP.Internal estimates of risk parameters are used in the Bank’s day-todaymanagement in line with regulation recommendations. Thus apartfrom calculating capital requirements, they are used for example whensetting delegated limits, granting new loans or reviewing existing loansto measure profitability, determine collective impairment and for internaland external reporting purposes.(1) Within the Group, the Corporate book includes institutions, corporates, specialised financing and sovereign states.2502012 Registration document and annual financial report - BNP PARIBAS