This report updates “Development of Credit Risk Management Based on Internal Rating System” released by the Bank of Japan in October 2001. Since then, financial institutions have been rapidly improving risk management techniques in order to accommodate dramatic changes in their credit risk profiles. In addition, the Basel II Framework was published last year and financial institutions’ preparation for adopting the framework has been in progress in tandem with the authorities’ domestic rule making. Considering these recent developments, this paper tries to present sound practices of credit risk management through internal rating systems, and also provide some important risk management issues to be further discussed and studied. It is our intention to use the topics in this paper to start in-depth discussions of risk management with financial institutions at the time of our on-site examinations and off-site monitoring and thereby encourage their advancement of credit risk management.

The contents of this report are as follows. In Chapter II, we discuss an outline of internal rating systems, which are a basic tool for enhancing credit risk management. The following chapters draw on sound practices of risk management through internal rating systems, focusing on the architecture of internal rating (Chapter III), rating process (Chapter IV), rating models (Chapter V), estimation of risk components (Chapter VI), uses of internal rating systems (Chapter VII), and validation of internal rating systems (Chapter VIII). In the last chapter, we also discuss the quantification of credit risk. In addition, there are many textboxes throughout the report, designed to elaborate issues which are secondary to the main text but still very important, such as our answers to FAQs from financial institutions and some new and thus not yet established ideas on advancing risk assessment techniques.