Internal rating systems and processes

The Group defines a rating system as all of the methods, processes, controls, data collection and IT systems that are used for the assessment of credit risk and for classification of exposures to a pool with a specified risk level, including the rules on the priority of rating models, if applicable, and the rules for overriding rating grades. Elements of the rating system include PD, LGD, CCF-EAD models (hereinafter: models) and methodologies for evaluating specialized lending.

Evaluation of the client’s credit risk in respect to its probability of default (PD) is based on a uniform rating scale, referred to as the Master Scale.

The Master Scale (MS) consists of 15 rating grades. where the given ratings are as follows:

Ratings 13 – 15 are procedural ones, reserved to exposures with deteriorated quality.

All the clients with available lending, whether or not they actually use the approved credit limits and all other participants of credit transactions should have a previously awarded rating and should be assigned to an appropriate pool.

An adequate credit or rating policy should specify the model to be used for rating purposes or a homogenous pool for a given client segment.

Each PD model used must be calibrated to MS based on the observed or estimated probability of default.

The rating for governments, central banks, international organizations, multilateral development banks and Institutions may be assigned based on a rating awarded by recognized rating agencies, mapped to the Master Scale. Should the above-mentioned entities have more than one classification awarded by recognized rating agencies (split rating) the rating corresponding to the second best risk shall be taken into account at all times. The table showing relationships between internal and external risk grades is presented in chapter 7.3 of the Disclosures. The Bank recognizes the following external rating agencies for comparison purposes: Fitch, Moody’s, Standard & Poor’s.

In case of retail customers, rating awarded through a behavioral model (behavioral rating) by default takes precedence over a rating awarded through an application model (application rating) if behavioral rating only is awarded. In case of corporate customers, awarded rating comes from a combination of a quantitative model based on an analysis of data from financial statements and on a qualitative model of customer including wages for each of components. Currently Bank is in a course of an implementation of an additional module in corporate models that is based on behavioral variables.

Procedural ratings (13. 14 and 15 according to the Master Scale) are awarded to clients showing signs of deteriorating borrowing capacity and creditworthiness or with overdue debt.

Procedural ratings by default take precedence over application ratings.

After the pre-conditions necessary to award any of the procedural ratings are no longer satisfied, ratings 13 and 14 expire immediately, while rating 15 either expires or is maintained for a “quarantine period”.

Description of the internal ratings process

1. Central governments and central banks

This exposure class is excluded permanently from the IRB approach.

2. Institutions

This exposure class is excluded permanently from the IRB approach.

3. Corporates. including SMEs. specialized lending and purchased corporate receivables

Exposure classes subject to the plan of gradual implementation of the IRB approach.

4. Retail exposures

PD models

The rating process in Bank Millennium is based on the following principles:

• Awarding risk grades to all customers and credit exposures;
• All credit decisions should be preceded by awarding a risk grade to the client;
• In the retail segment, the rating process is based on PD scoring/rating models;
• The rating process is separated and independent from the credit decision process.

The presented rating principles apply to all categories of retail exposures: retail exposures to individuals secured by residential real estate, qualifying revolving retail exposures and other retail exposures.

The class of retail exposures to individuals secured by residential real estate include exposures which are mortgage loans or home equity loans granted to retail clients (small businesses and private individuals) and secured by mortgage.

The class of qualifying revolving retail exposures includes exposures to natural persons which are unsecured, renewable, with total exposure not exceeding EUR 100.000 and which meet the requirement of low volatility of loss rates.

All the retail exposures that do not qualify to the above categories are treated as other retail exposures. They are covered by the IRB roll-out plan, and according to the last IRB permission, IRB Approval Pack regarding these exposures was delivered on the 30^th June, 2015 (update of that Approval Pack will be submitted at the turn of 2017 and 2018).

In the rating process, the powers are allocated as follows:

• Data input;
• Verification of data;
• Awarding of the final risk grade (automated decision).

Model-based risk grades and procedural ratings are awarded automatically and are not subject to expert adjustments.

In the rating process. the Bank uses data from various available sources:

•  internal sources (Bank’s IT systems);
•  external sources (Biuro Informacji Kredytowej S.A.);
• data received from customers.

With respect to probability of default (PD) models for retail exposures, there is a rating system in place for microbusinesses and a rating system for private individuals. Both systems use behavioral scoring models and application scoring models designed for specific client and/or product groups. Procedural ratings are awarded to clients showing signs of deteriorating borrowing capacity and creditworthiness or with past due debt.

A procedural rating has the priority in use. If the client has no procedural rating then the behavioral rating should be used, provided that it has been awarded. Behavioral rating is awarded for the first time after three months of the client’s cooperation with the Bank and then monthly, provided that the client’s accounts meet the requirements of the behavioral model. If the client has no behavioral or procedural rating then the application rating should be used.

LGD models

Loss Given Default (LGD) models have been built for the following two portfolios:

•  unsecured portfolio for retail clients.
• portfolio secured by residential real estate for retail clients.

Pursuant to CRR. as amended, banks must estimate LGD parameters using data on defaulted exposures from all the available sources, taking into account all information that is significant for the estimation of economic loss levels.

Accordingly, the Bank has estimated LGD parameters using a database that contains all the defaults resulting from quantitative and qualitative premises included in default definitions.

According to the LGD calculation methodology, the main factors in the calculation include: probability of cure or completion of the client recovery process, value of recoveries, costs and discount rate.

The Bank has taken the following approach to building LGD models:

• Estimate the probability of the path of cure from the default status. i.e. a probability tree;
• Estimate loss parameters for each path of cure from default.

Loss given default is estimated at a transaction level.

Exposure at Default (EAD) models

An EAD model has been built for retail portfolio exposures. When estimating EAD, exposure at default was compared to the value of the limit and the book value of the exposure observed one year before the default event. Credit Conversion Factor (CCF) parameters have been calculated for product groups for which an off-balance sheet exposure could occur and where the Bank had a significant number of observations that enabled statistical conclusions to be drawn. i.e. for overdraft limits and for credit cards. In the case of guarantees, where the number of observations was too low to carry out statistical analyses, a conservative CCF value was used. At the same time, EAD model for RRE portfolio was not developed due to immaterial number of observations.

5. Equity exposures

In equity exposures. the Millennium Group classifies shares and equity instruments held by any of the Bank’s units. On the consolidated basis, however, the shares representing investments in subsidiaries are excluded, since those are classified as intragroup transactions. However, due to the fact that the total value of the Group’s equity portfolio is insignificant, it has been decided that these exposures should be excluded from the IRB approach permanently and the capital requirement for these exposures should be calculated based on the standardized approach.

6. Exposure values and adjustments

The below table presents the basic aggregates and parameters used in calculation of own funds requirements in IRB method. As for exposure classes under IRB method, exposure amounts, CCF’s, average PD’s, debtors amount, average LGD’s, risk-weighted assets, risk density, expected loss and specific credit risk adjustments, break downed by probability of default (PD) brackets are showed.

Exposures to credit risk by exposure classes and PD brackets

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	PD scale	Original on-balance-sheet gross exposures	Off-balance- sheet exposures pre-CCF	Average CCF	EAD post CRM and post CCF	Average PD	Number of obligors	Average LGD	RWAs	RWA density	EL	Value adjustments and provisions
QRRE	0.00 do <0.15	206 297	1 133 041	77.65%	1 086 081	0.08%	148 249	81.98%	47 145	4.34%	712	386
QRRE	0.15 do <0.25	112 053	262 370	82.57%	328 702	0.20%	58 807	77.48%	28 710	8.73%	509	234
QRRE	0.25 to <0.50	119 677	168 826	84.23%	261 874	0.39%	45 961	74.69%	37 965	14.50%	763	244
QRRE	0.50 to <0.75	162 764	138 751	84.10%	279 457	0.71%	46 869	75.49%	65 714	23.51%	1 498	367
QRRE	0.75 to <2.50	324 395	172 099	86.63%	473 478	1.67%	70 133	73.70%	205 915	43.49%	5 816	794
QRRE	2.50 to <10.00	215 105	64 265	85.36%	269 959	5.73%	38 415	75.31%	280 717	103.99%	11 735	944
QRRE	10.00 to <100.00	114 049	19 350	85.31%	130 556	27.84%	18 425	78.54%	278 716	213.48%	28 238	1 357
QRRE	100.00 (default)	103 936	3 866	0.00%	103 936	100.00%	17 095	97.98%	4 378	4.21%	101 840	48 117
QRRE	Razem	1 358 277	1 962 569	80.29%	2 934 042	5.73%	443 954	78.67%	949 259	32.35%	151 112	52 442
Residential Retail	0.00 do <0.15	17 418 586	66 358	0.00%	17 418 586	0.08%	80 660	31.40%	1 159 233	6.66%	4 375	14 327
Residential Retail	0.15 do <0.25	2 807 693	13 864	0.14%	2 807 712	0.19%	11 769	32.14%	369 272	13.15%	1 725	2 901
Residential Retail	0.25 to <0.50	1 811 681	10 440	1.96%	1 811 886	0.39%	7 602	32.25%	404 818	22.34%	2 279	2 708
Residential Retail	0.50 to <0.75	1 365 964	6 827	0.00%	1 365 964	0.71%	5 384	32.52%	468 281	34.28%	3 154	2 641
Residential Retail	0.75 to <2.50	1 722 193	12 784	0.00%	1 722 193	1.66%	6 946	32.54%	1 022 123	59.35%	9 324	4 456
Residential Retail	2.50 to <10.00	1 045 814	5 343	0.02%	1 045 815	5.79%	4 079	32.40%	1 235 080	118.10%	19 576	5 340
Residential Retail	10.00 to <100.00	809 295	647	0.00%	809 295	19.97%	2 895	33.14%	1 501 917	185.58%	53 956	9 294
Residential Retail	100.00 (default)	854 927	0		854 927	100.00%	2 640	64.07%	126 447	14.79%	547 748	224 861
Residential Retail	Total	27 836 153	116 262	0.19%	27 836 378	4.10%	121 975	32.75%	6 287 171	22.59%	642 138	266 528
Total (all classes)		29 194 430	2 078 831	75.81%	30 770 420	4.26%	516 058	37.12%	7 236 430	23.52%	793 250	318 969

7. Drivers that impacted on the loss experience, in conjunction with the actual results in a longer term

For both analyzed portfolio, modeled loss amounts were much higher than actual figures. We can therefore state that there were no unexpected losses associated with LGD levels and the model used has proven to be sufficiently conservative.

The Group does not have companies conducting credit activity abroad. (CRR 452.j)