New Capital Accord: Implications for Credit Risk Management
The Basel Committee on Banking Supervision had released in June 1999 the first Consultative Paper on a New Capital Adequacy Framework with the intention of replacing the current broad-brush 1988 Accord. The Basel Committee has released a Second Consultative Document in January 2001, which contains refined proposals for the three pillars of the New Accord – Minimum Capital Requirements, Supervisory Review and Market Discipline.
The Committee proposes two approaches, viz., Standardised and Internal Rating Based (IRB) for estimating regulatory capital. Under the standardised approach, the Committee desires neither to produce a net increase nor a net decrease, on an average, in minimum regulatory capital, even after accounting for operational risk. Under the IRB approach, the Committee’s ultimate goals are to ensure that the overall level of regulatory capital is sufficient to address the underlying credit risks and also provides capital incentives relative to the standardised approach, i.e., a reduction in the risk weighted assets of 2% to 3% (foundation IRB approach) and 90% of the capital requirement under foundation approach for advanced IRB approach to encourage banks to adopt IRB approach for providing capital.
The minimum capital adequacy ratio would continue to be 8% of the risk-weighted assets, which cover capital requirements for market (trading book), credit and operational risks. For credit risk, the range of options to estimate capital extends to include a standardised, a foundation IRB and an advanced IRB approaches.
Under the standardised approach, preferential risk weights in the range of 0%, 20%, 50%, 100% and 150% would be assigned on the basis of ratings given by external credit assessment institutions.
Orientation of the IRB Approach
Banks’ internal measures of credit risk are based on assessments of the risk characteristics of both the borrower and the specific type of transaction. The probability of default (PD) of a borrower or group of borrowers is the central measurable concept on which the IRB approach is built. The PD of a borrower does not, however, provide the complete picture of the potential credit loss. Banks should also seek to measure how much they will lose should a borrower default on an obligation. This is contingent upon two elements. First, the magnitude of likely loss on the exposure: this is termed the Loss Given Default (LGD), and is expressed as a percentage of the exposure. Secondly, the loss is contingent upon the amount to which the bank was exposed to the borrower at the time of default, commonly expressed as Exposure at Default (EAD). These three components (PD, LGD, EAD) combine to provide a measure of expected intrinsic, or economic, loss. The IRB approach also takes into account the maturity (M) of exposures. Thus, the derivation of risk weights is dependent on estimates of the PD, LGD and, in some cases, M, that are attached to an exposure. These components (PD, LGD, EAD, M) form the basic inputs to the IRB approach, and consequently the capital requirements derived from it.
The Committee proposes two approaches – foundation and advanced – as an alternative to standardised approach for assigning preferential risk weights.
Under the foundation approach, banks, which comply with certain minimum requirements viz. comprehensive credit rating system with capability to quantify Probability of Default (PD) could assign preferential risk weights, with the data on Loss Given Default (LGD) and Exposure at Default (EAD) provided by the national supervisors. In order to qualify for adopting the foundation approach, the internal credit rating system should have the following parameters/conditions:
- Each borrower within a portfolio must be assigned the rating before a loan is originated.
- Minimum of 6 to 9 borrower grades for performing loans and a minimum of 2 grades for non-performing loans.
- Meaningful distribution of exposure across grades and not more than 30% of the gross exposures in any one borrower grade.
- Each individual rating assignment must be subject to an independent review or approval by the Loan Review Department.
- Rating must be updated at least on annual basis.
- The Board of Directors must approve all material aspects of the rating and PD estimation.
- Internal and External audit must review annually, the banks’ rating system including the quantification of internal ratings.
- Banks should have individual credit risk control units that are responsible for the design, implementation and performance of internal rating systems. These units should be functionally independent.
- Members of staff responsible for rating process should be adequately qualified and trained.
- Internal rating must be explicitly linked with the banks’ internal assessment of capital adequacy in line with requirements of Pillar 2.
- Banks must have in place sound stress testing process for the assessment of capital adequacy.
- Banks must have a credible track record in the use of internal ratings at least for the last 3 years.
- Banks must have robust systems in place to evaluate the accuracy and consistency with regard to the system, processing and the estimation of PDs.
- Banks must disclose in greater detail the rating process, risk factors, validation etc. of the rating system.
Under the advanced approach, banks would be allowed to use their own estimates of PD, LGD and EAD, which could be validated by the supervisors. Under both the approaches, risk weights would be expressed as a single continuous function of the PD, LGD and EAD. The IRB approach, therefore, does not rely on supervisory determined risk buckets as in the case of standardised approach. The Committee has proposed an IRB approach for retail loan portfolio, having homogenous characteristics distinct from that for the corporate portfolio. The Committee is also working towards developing an appropriate IRB approach relating to project finance.
The adoption of the New Accord, in the proposed format, requires substantial upgradation of the existing credit risk management systems. The New Accord also provided in-built capital incentives for banks, which are equipped to adopt foundation or advanced IRB approach. Banks may, therefore, upgrade the credit risk management systems for optimising capital.