There are many challenges in today’s financial market, which is why credit risk management has become more complex and data-oriented than ever before. As institutions aim to increase their internal credit risk assessment. There is one practice through which this becomes easy, which is benchmarking internal credit ratings using external ratings. Using this approach not only strengthens risk management but it is also responsible for aligning internal credit practices with regulatory expectations with market standards.

External ratings like those which are provided by agencies like ICRA Rating Agency Limited are trusted indicators of creditworthiness. When it is used as reference for internal assessments, they assist to improve the consistency, clarity, and comparability of internal credit models. Let’s explore how institutions can increase external ratings across four key dimensions to build a more resilient and reliable credit risk structure.

1. Calibration of Internal Rating Scales

One of the best steps in integrating external ratings into internal processes is the calibration of internal rating scales. Most financial institutions use their own custom-made credit rating systems that are designed to fit their unique portfolios and risk assessments. These systems might use grades like A, AA, etc.

However, without alignment to widely accepted standards like AAA to D scale used by credit rating agencies. The values of these ratings may be different across institutions. By mapping internal scales to external ratings.

Institutions can:

• Increase consistency in credit risk assessment
• Promote transparency within and outside the organization
• Facilitate industry-wide comparability and benchmarking

2. Validation of Internal Models

The credit rating system is incomplete in the absence of strong verification. External ratings provide a valuable instrument for verifying models by serving as an independent reference point. Institutions can check the predictive power and precision of their internal models by comparing them to established external ratings.

One of the commonly used validation techniques is the RORAC (Return on Risk-Adjusted Capital), which measures the model’s ability to discriminate between defaulting and non-defaulting exposures. By evaluating metrics such as the Area Under the Curve (AUC), financial institutions can assess whether their internal ratings are in alignment with real-world outcomes.

Moreover, this validation process supports stronger internal regulatories. Independent model validation teams can be used for external benchmarks to identify potential weaknesses, recalibrate models where it is required to, and document the strongness of internal rating systems for regulatory scrutiny.

3. Risk Appetite and Investment Policy Alignment

External ratings also play an important role in helping institutions define and enforce their risk level and investment policies. By referencing standardised external benchmarks all the institutions can better classify and manage credit structures.

• Ensure consistency in credit portfolio diversification
• Maintain alignment with governance and policy
• Avoid breaches of risk limits

4. Dual Rating Approach

A particularly powerful strategy for improving credit assessment is the Dual Rating Approach, where both internal and external ratings are maintained for the same type of risk. This dual perspective offers a more balanced view of the creditworthiness of an individual.

Institutions get:

• Deeper insights into credit risk by increasing independent assessments
• A difference between internal and external ratings can indicate the need for improved risk monitoring and further investigation.
• Stronger early warning systems, which help identify credit quality before it leads to losses.
• More accurate provisioning. By using multiple data points to control expected credit losses under IFRS 9 or similar working structure.

Conclusion

Benchmarking internal credit ratings against external ratings is no longer just a best practice, but it is a strategic need more. In a world where governance standards are tightening and markets are volatile, with increasing demand for transparency all the financial institutions must evolve their risk framework to meet these expectations.

By calibrating internal rating scales, validating model accuracy while aligning with risk appetite policies, and adopting a dual rating approach the institutions can significantly increase the strength of their credit risk management exercise. Partnering with a credible rating agency like ICRA Rating Agency Limited provides an external view and need to build trust and resilience in credit decision-making