Gaining an edge from Basel
The recent recommendations of the Basel Committee are set to usher in a period of upheaval for many participants in the banking sector. Standard & Poor’s Anthony Albert looks at how to gain a competitive advantage in credit risk management in the light of Basel II.
The banking landscape is undergoing considerable change, in particular because of the potential impact of the actions proposed by the Basel Committee on banking regulation, commonly known as Basel II.
Standard & Poor’s has published a number of articles commenting in detail on the consultative documents published by the Basel Committee that will affect the three major risk categories, namely credit, market and operational risk, together with their likely implications.
The objective of this article is to draw some key conclusions from the perspective of the top management of banks on how to link a bank’s level of capital to its individual risk profile. In order to fulfil the Basel requirements, financial institutions, whether private or public, will need to address the following key issues:
• Banks will be encouraged to better align their capital with their underlying risk profile. This will be achieved through improved management of the risk assets, not only at the individual transaction level, but also at the portfolio level, whether in terms of regulatory or economic capital.
• Banks will be encouraged to enhance their risk management capabilities, using both on-balance sheet and off-balance sheet techniques, from new approaches to the sector focus of their lending, to measuring the quality of the lending and to enhancing their risk mitigation techniques.
• Banks will require far more and better quality data, covering probabilities of default, losses given default, and default correlations. These data will be fed into the method of calculating not only the level of regulatory capital required under the Basel II approach but also the model used to produce the level of economic capital.
Impact of the first Basel Accord
The primary objective of Basel I in 1988 was to reinforce the minimum level of capital within the banking system: over the last 20 years U.S. banks demonstrated a near 50% improvement in the ratio of total equity to total assets (see table). But this success has, to a great extent, been overshadowed by a number of potentially negative consequences, of which the most important are:
• The simple but effective risk weighting for all corporate risk of 100% across the board did not differentiate sufficiently clearly between different asset risk categories. This effectively encouraged banks to go downmarket in the search for greater returns, by underwriting some higher risk obligors.
• At the same time, senior management did not sufficiently link return on capital with use of capital: some important distortions have resulted as a consequence, with respect to the financing of certain segments of the corporate market, such as the small- and medium-sized segment.
• Basel I requirements were not maturity sensitive, and included only to a limited extent the question of valuing collateral for capital weighting purposes.
As a result, banks have started to look more closely at their return on capital and to develop their off-balance sheet activities by increasing their use of collateralised debt obligations (CDOs), collateralised loan obligations (CLOs), and other similar vehicles in order to manage regulatory capital more efficiently. It remains a debatable point whether the resulting capital actually reflects the real level of risk associated with individual bank activities.
Objectives of Basel II
The regulators encouraged banks, under Basel I, to better understand the risks contained in their loan portfolios and maintained the regulatory capital requirement at an arbitrary level of 8% of such weighted risk assets. The regulators also recognised that the risk weighting of bank assets under Basel I did not fully reflect the actual underlying level of risk and sought to add a new dimension, namely a more sophisticated mechanism to link risk-weighted assets and capital.
The regulators are now encouraging banks to improve their internal risk management systems, and to use such systems to calculate, under the Advanced Internal Ratings-Based (IRB) approach, the level of economic capital required. However, no agreement has yet been reached on how such improvements could result in any significantly lower level of regulatory capital than is the case today.
Furthermore, under Basel II, banks will have to communicate their risk policies more clearly to the markets – otherwise the markets could penalise those banks perceived to be holding a level of capital that is not commensurate to the published or perceived risk profile of the bank’s assets. For the first time, return on economic capital will join the more traditional return on investment as one of the key ratios of performance for bank management.
Some key consequences of Basel II
The consequences of the new approach will be felt in different ways, but perhaps most notably in the area of asset allocation among the various classes of assets. This could well result in significant changes in the strategies of individual banks, creating important changes in the lending markets. The following three implications with the broadest perceived consequences illustrate this point:
Economics of lending to small- and medium-sized enterprises Under Basel I, banks increased their lending to riskier asset classes, such as small- and medium-sized enterprises (SMEs), given the “one size fits all” risk weighting of 100%. It is the clear intention of Basel II to link riskier lending to higher capital requirements.
At the same time, there is increasing empirical evidence to show that lending to SMEs may well turn out to be less profitable than previously thought. As a result banks may well be overestimating the true profitability of this customer segment, while underestimating the correct level of the effective losses.
Regulators could therefore be faced with a situation in which weaker banks continue lending to riskier obligors, partly because SMEs are their natural customer base and partly because of the discrepancy between the standardised and IRB approaches used to evaluate capital requirements.
In addition there is the risk of a potential credit crunch: larger banks, which are expected to apply the IRB approach, could well reduce their corporate exposure, especially to those at the lower end of the ratings spectrum at the bottom of the economic cycle.
Trade-off between probability of default and loss given default
The Basel Committee has proposed two different curves to represent the probability of default (PD) and the loss given default (LGD). Mathematically, the PD is represented by a straight line, while the LGD is represented by a concave curve. The primary consequence is that under Basel II, regulatory capital will be more sensitive to LGD than PD for riskier loans.
There will be some important consequences for banks:
• Banks may be able to reduce their capital requirements by improving the structure of their loan transactions: collateral will take on a greater importance than ever before.
• However, from a credit analysis point of view, banks should not be encouraged to return to the “lending on collateral” typical of past lending policies, and should continue with the cashflow-based lending approach to avoid any risk of an “asset bubble” distorting lending decisions.
• Correct valuation of collateral will become an increasingly important factor as banks take greater account of collateral values as the primary source of credit risk mitigation.
Penalising lending to the retail sector
As lending to large multinationals has decreased in importance at most banks due to low returns both in absolute and risk adjusted terms, retail lending has appeared both more profitable and more attractive in terms of capital requirements.
The current guidelines under Basel II would require banks to hold capital for both expected losses, reflecting the banks’ experience of defaults over time, as well as for unexpected losses, which could be due to some special macroeconomic situation. However, as most retail loans are unsecured, from a risk point of view, this implies that retail loan portfolios will show relatively high expected losses and relatively low unexpected losses. Should banks have to hold a given level of regulatory capital for unexpected losses as determined by Basel II, then banks could find themselves holding excessive levels of capital compared with the level determined by their economic model.
Finally, regulated banks active in the retail sector could be put at a significant disadvantage vis-à-vis unregulated competitors, should these capital adequacy guidelines be implemented in their present form.
Basel II and its effects on competition
Traditionally, banks have competed in their respective markets either by enhancing the value of a product (which is very difficult with a commoditised product common to most banking markets) or more typically by simply lowering the price of their services. The latter approach will no longer remain a viable strategy under Basel II, due to three key macro factors:
• The increased convergence of loan and bond pricing, given the development of bank internal rating systems.
• The resulting application of credit mitigation techniques, following the methodology adopted under Basel II.
• The fact that banks’ business models are increasingly moving away from the traditional “originate and hold” approach to loans toward an approach that could be described as “originate and place”, typically selling on to a central portfolio management unit.
Banks will be strongly encouraged to act on two principal fronts: their ability to generate improved returns from their allocation of capital to existing businesses, and the amount of capital needed by their individual businesses.
Previously, assets making vastly different contributions to portfolio credit risk received similar regulatory capital treatment. However, under Basel II, there will be significant pressure to improve the portfolio return by discarding flat pricing policy across the credit risk spectrum and by moving toward a pricing policy that better aligns the loan margin with the respective customer risk.
Under Basel I, a bank was encouraged to reduce its risk of insolvency by raising its tier-one capital. Banks undertook asset securitisations in order to reduce their capital requirements by removing from the balance sheet those assets with relatively high marginal regulatory capital requirements but that contributed relatively little to portfolio credit risk. The result is that those assets for which regulatory capital requirements are low tended to remain on the balance sheet.
These pressures will inevitably result in important competitive implications. Banks will no longer be able to follow the hitherto relatively safe but undifferentiated strategy of accepting a given level of market pricing, holding almost all assets underwritten, and not differentiating the portfolio sufficiently explicitly.
Banks will therefore seek to gain an advantage by selecting those market niches that play to their strengths, notably in terms of their ability to manage the risk/return aspects of customers, and could well exit certain activities and customer segments based on their relative impact on regulatory capital. These banks will seek to apply more advanced risk management skills, in particular those skills: 1) used to address risk transfer issues by way of securitisation and CLOs; 2) required to seek out new ways of mitigating credit risk through the use of collateral and netting techniques; and 3) required to create increasing liquidity in the credit markets.
Risk management: key conclusions
The adoption of the guidelines proposed under Basel II could well split banks into different categories, with the more advanced banks driving their risk management activities to a higher degree of sophistication. In addition, Basel II will strongly encourage the use of historical data, increased benchmarking of portfolios, and analysing data in greater detail and depth.
Under Basel II, the bank seeking to gain a competitive advantage can be expected to focus on most, if not all, of the following elements:
Striving for improved data for risk management systems
Banks will inevitably require large amounts of data to feed their models: data regarding probabilities of default, recovery levels across the various categories of lending assets, both rated and unrated entities, as well databases feeding transition matrices and correlations.
Over time, the ability to analyse information about risk will become more important than just possessing it, once the quality, detail and timeliness of the data regarding risk have become sufficiently robust.
Reviewing each bank’s experience with risk models
Most of the new portfolio credit models were developed during the latter part of the 1990s, a period of benign economic growth. During this period the models focused primarily on the default rate, and somewhat ignored recovery levels. However, it is precisely during downturns that banks have to realize their assets, only to discover that the actual recovery levels fall well below those assumed in the models.
A given credit model could considerably underestimate a bank’s need for capital when calculated through the economic cycle. This in turn could give rise to the particular situation that regulators seek to avoid, referred to as “procyclicality”. This term refers to the tendency of banks to reduce substantially their lending at certain points in the lending cycle. The consequences of incorrect assumptions built into credit models could result in banks overemphasizing negative trends in expected loss, and therefore in incremental capital requirements, just at the point in time when regulators seek to deter banks from pursuing restrictive lending policies, which could lead to a “credit crunch”.
Learning to live with capital volatility
The constitution of a bank’s loan portfolio will vary over time, and so will the portfolio’s level of expected loss. The manner in which the bank’s own model calculates capital requirements will focus management attention on the potential volatility of both regulatory and economic capital required.
The challenge for banks lies in managing the greater focus on profitability, which should in turn lead to improved financial performance, while at the same time ensuring that the management of risk weighted assets does not result in declining capital ratios. Communicating these changes to the market and to regulators will become a pre-eminent challenge for these institutions.
Credit
Standard & Poor’s has published a number of articles commenting in detail on the consultative documents published by the Basel Committee that will affect the three major risk categories, namely credit, market and operational risk, together with their likely implications.
The objective of this article is to draw some key conclusions from the perspective of the top management of banks on how to link a bank’s level of capital to its individual risk profile. In order to fulfil the Basel requirements, financial institutions, whether private or public, will need to address the following key issues:
• Banks will be encouraged to better align their capital with their underlying risk profile. This will be achieved through improved management of the risk assets, not only at the individual transaction level, but also at the portfolio level, whether in terms of regulatory or economic capital.
• Banks will be encouraged to enhance their risk management capabilities, using both on-balance sheet and off-balance sheet techniques, from new approaches to the sector focus of their lending, to measuring the quality of the lending and to enhancing their risk mitigation techniques.
• Banks will require far more and better quality data, covering probabilities of default, losses given default, and default correlations. These data will be fed into the method of calculating not only the level of regulatory capital required under the Basel II approach but also the model used to produce the level of economic capital.
Impact of the first Basel Accord
The primary objective of Basel I in 1988 was to reinforce the minimum level of capital within the banking system: over the last 20 years U.S. banks demonstrated a near 50% improvement in the ratio of total equity to total assets (see table). But this success has, to a great extent, been overshadowed by a number of potentially negative consequences, of which the most important are:
• The simple but effective risk weighting for all corporate risk of 100% across the board did not differentiate sufficiently clearly between different asset risk categories. This effectively encouraged banks to go downmarket in the search for greater returns, by underwriting some higher risk obligors.
• At the same time, senior management did not sufficiently link return on capital with use of capital: some important distortions have resulted as a consequence, with respect to the financing of certain segments of the corporate market, such as the small- and medium-sized segment.
• Basel I requirements were not maturity sensitive, and included only to a limited extent the question of valuing collateral for capital weighting purposes.
As a result, banks have started to look more closely at their return on capital and to develop their off-balance sheet activities by increasing their use of collateralised debt obligations (CDOs), collateralised loan obligations (CLOs), and other similar vehicles in order to manage regulatory capital more efficiently. It remains a debatable point whether the resulting capital actually reflects the real level of risk associated with individual bank activities.
Objectives of Basel II
The regulators encouraged banks, under Basel I, to better understand the risks contained in their loan portfolios and maintained the regulatory capital requirement at an arbitrary level of 8% of such weighted risk assets. The regulators also recognised that the risk weighting of bank assets under Basel I did not fully reflect the actual underlying level of risk and sought to add a new dimension, namely a more sophisticated mechanism to link risk-weighted assets and capital.
The regulators are now encouraging banks to improve their internal risk management systems, and to use such systems to calculate, under the Advanced Internal Ratings-Based (IRB) approach, the level of economic capital required. However, no agreement has yet been reached on how such improvements could result in any significantly lower level of regulatory capital than is the case today.
Furthermore, under Basel II, banks will have to communicate their risk policies more clearly to the markets – otherwise the markets could penalise those banks perceived to be holding a level of capital that is not commensurate to the published or perceived risk profile of the bank’s assets. For the first time, return on economic capital will join the more traditional return on investment as one of the key ratios of performance for bank management.
Some key consequences of Basel II
The consequences of the new approach will be felt in different ways, but perhaps most notably in the area of asset allocation among the various classes of assets. This could well result in significant changes in the strategies of individual banks, creating important changes in the lending markets. The following three implications with the broadest perceived consequences illustrate this point:
Economics of lending to small- and medium-sized enterprises Under Basel I, banks increased their lending to riskier asset classes, such as small- and medium-sized enterprises (SMEs), given the “one size fits all” risk weighting of 100%. It is the clear intention of Basel II to link riskier lending to higher capital requirements.
At the same time, there is increasing empirical evidence to show that lending to SMEs may well turn out to be less profitable than previously thought. As a result banks may well be overestimating the true profitability of this customer segment, while underestimating the correct level of the effective losses.
Regulators could therefore be faced with a situation in which weaker banks continue lending to riskier obligors, partly because SMEs are their natural customer base and partly because of the discrepancy between the standardised and IRB approaches used to evaluate capital requirements.
In addition there is the risk of a potential credit crunch: larger banks, which are expected to apply the IRB approach, could well reduce their corporate exposure, especially to those at the lower end of the ratings spectrum at the bottom of the economic cycle.
Trade-off between probability of default and loss given default
The Basel Committee has proposed two different curves to represent the probability of default (PD) and the loss given default (LGD). Mathematically, the PD is represented by a straight line, while the LGD is represented by a concave curve. The primary consequence is that under Basel II, regulatory capital will be more sensitive to LGD than PD for riskier loans.
There will be some important consequences for banks:
• Banks may be able to reduce their capital requirements by improving the structure of their loan transactions: collateral will take on a greater importance than ever before.
• However, from a credit analysis point of view, banks should not be encouraged to return to the “lending on collateral” typical of past lending policies, and should continue with the cashflow-based lending approach to avoid any risk of an “asset bubble” distorting lending decisions.
• Correct valuation of collateral will become an increasingly important factor as banks take greater account of collateral values as the primary source of credit risk mitigation.
Penalising lending to the retail sector
As lending to large multinationals has decreased in importance at most banks due to low returns both in absolute and risk adjusted terms, retail lending has appeared both more profitable and more attractive in terms of capital requirements.
The current guidelines under Basel II would require banks to hold capital for both expected losses, reflecting the banks’ experience of defaults over time, as well as for unexpected losses, which could be due to some special macroeconomic situation. However, as most retail loans are unsecured, from a risk point of view, this implies that retail loan portfolios will show relatively high expected losses and relatively low unexpected losses. Should banks have to hold a given level of regulatory capital for unexpected losses as determined by Basel II, then banks could find themselves holding excessive levels of capital compared with the level determined by their economic model.
Finally, regulated banks active in the retail sector could be put at a significant disadvantage vis-à-vis unregulated competitors, should these capital adequacy guidelines be implemented in their present form.
Basel II and its effects on competition
Traditionally, banks have competed in their respective markets either by enhancing the value of a product (which is very difficult with a commoditised product common to most banking markets) or more typically by simply lowering the price of their services. The latter approach will no longer remain a viable strategy under Basel II, due to three key macro factors:
• The increased convergence of loan and bond pricing, given the development of bank internal rating systems.
• The resulting application of credit mitigation techniques, following the methodology adopted under Basel II.
• The fact that banks’ business models are increasingly moving away from the traditional “originate and hold” approach to loans toward an approach that could be described as “originate and place”, typically selling on to a central portfolio management unit.
Banks will be strongly encouraged to act on two principal fronts: their ability to generate improved returns from their allocation of capital to existing businesses, and the amount of capital needed by their individual businesses.
Previously, assets making vastly different contributions to portfolio credit risk received similar regulatory capital treatment. However, under Basel II, there will be significant pressure to improve the portfolio return by discarding flat pricing policy across the credit risk spectrum and by moving toward a pricing policy that better aligns the loan margin with the respective customer risk.
Under Basel I, a bank was encouraged to reduce its risk of insolvency by raising its tier-one capital. Banks undertook asset securitisations in order to reduce their capital requirements by removing from the balance sheet those assets with relatively high marginal regulatory capital requirements but that contributed relatively little to portfolio credit risk. The result is that those assets for which regulatory capital requirements are low tended to remain on the balance sheet.
These pressures will inevitably result in important competitive implications. Banks will no longer be able to follow the hitherto relatively safe but undifferentiated strategy of accepting a given level of market pricing, holding almost all assets underwritten, and not differentiating the portfolio sufficiently explicitly.
Banks will therefore seek to gain an advantage by selecting those market niches that play to their strengths, notably in terms of their ability to manage the risk/return aspects of customers, and could well exit certain activities and customer segments based on their relative impact on regulatory capital. These banks will seek to apply more advanced risk management skills, in particular those skills: 1) used to address risk transfer issues by way of securitisation and CLOs; 2) required to seek out new ways of mitigating credit risk through the use of collateral and netting techniques; and 3) required to create increasing liquidity in the credit markets.
Risk management: key conclusions
The adoption of the guidelines proposed under Basel II could well split banks into different categories, with the more advanced banks driving their risk management activities to a higher degree of sophistication. In addition, Basel II will strongly encourage the use of historical data, increased benchmarking of portfolios, and analysing data in greater detail and depth.
Under Basel II, the bank seeking to gain a competitive advantage can be expected to focus on most, if not all, of the following elements:
Striving for improved data for risk management systems
Banks will inevitably require large amounts of data to feed their models: data regarding probabilities of default, recovery levels across the various categories of lending assets, both rated and unrated entities, as well databases feeding transition matrices and correlations.
Over time, the ability to analyse information about risk will become more important than just possessing it, once the quality, detail and timeliness of the data regarding risk have become sufficiently robust.
Reviewing each bank’s experience with risk models
Most of the new portfolio credit models were developed during the latter part of the 1990s, a period of benign economic growth. During this period the models focused primarily on the default rate, and somewhat ignored recovery levels. However, it is precisely during downturns that banks have to realize their assets, only to discover that the actual recovery levels fall well below those assumed in the models.
A given credit model could considerably underestimate a bank’s need for capital when calculated through the economic cycle. This in turn could give rise to the particular situation that regulators seek to avoid, referred to as “procyclicality”. This term refers to the tendency of banks to reduce substantially their lending at certain points in the lending cycle. The consequences of incorrect assumptions built into credit models could result in banks overemphasizing negative trends in expected loss, and therefore in incremental capital requirements, just at the point in time when regulators seek to deter banks from pursuing restrictive lending policies, which could lead to a “credit crunch”.
Learning to live with capital volatility
The constitution of a bank’s loan portfolio will vary over time, and so will the portfolio’s level of expected loss. The manner in which the bank’s own model calculates capital requirements will focus management attention on the potential volatility of both regulatory and economic capital required.
The challenge for banks lies in managing the greater focus on profitability, which should in turn lead to improved financial performance, while at the same time ensuring that the management of risk weighted assets does not result in declining capital ratios. Communicating these changes to the market and to regulators will become a pre-eminent challenge for these institutions.
Credit
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