Title: The Reform of Regulatory Capital The Challenges of the New Proposal
1Risk-Focused Supervision.How is Risk Defined?
Financial Stability Institute and the Committee
of Banking supervisors of West and Central
Africa 8-12 April 2002
Jean-Philippe Svoronos Basel Committee on Banking
Supervision
2Overview
- Risks in Banking proportions
- Risks in Banking definitions.
- Risk Factors The Example of Credit Risk
- Risk management Credit Risk
31. Risks in Banking
- A bank that does not take risk is not a bank
- Banks survive by accepting risks and prosper by
managing them adequately - Risk taking is banks crucial economic role and
the reason for their existence - But adequate management of risks has, over
time, become more difficult and complex
41. Risks in Banking proportions
- Banking risks
- Credit Risk
- Default risk
- Country Risk
- Settlement risk
- Market Risks
- Liquidity Risk
- Interest Rate Risk
- Operational risk
- Reputational Risk
51. Why is Credit Risk So Important?
- Credit risk continues to be the primary source of
problems at banks - Implying that most banks that have gone under
were hit by credit risk - The effective management of credit risk is
essential to the long-term success of any bank
62. Risks in banking what is Credit Risk?
- Credit risk is most simply defined as the
potential that a banks borrower or counterparty
will fail to meet its obligations in accordance
with agreed terms. - Credit risk exists throughout the activities of a
bank - Loans are the largest and most obvious source
- Credit risk exists in both the banking and
trading book - Credit risk exists on and off balance sheet
72. Risks in Banking What is Market Risk?
- Risk of losses in on-balance sheet and
off-balance-sheet positions arising from
movements in market prices. - Examples
- Interest rate risk
- Foreign exchange risk
- Equity position risk
- Commodity position risk
8Credit risk and market risk comparedReturn
distributions
- Market risk is significantly different in nature
from credit risk - Credit returns are skewed, with a long fat tail
- Market returns are normally distributed
(bell-shaped) - Market risks
- Often highly correlated
- Can be reduced through hedges
- Can only be slightly reduced through
diversification - Credit risk
- Less correlated
- Can be reduced though diversification
- Hedges (i.e. credit derivatives) still in state
of development
9Typical Distribution of Credit Returns
Gains
Losses
10Typical Distribution of market returns
Losses
Gains
112. Risks in Banking What is Liquidity Risk?
- The ability for a bank to fund increases in
assets and meet obligations/payments as they come
due. - Sound liquidity management one of the most
important activities conducted by a bank - The importance of liquidity transcends the
individual bank a liquidity shortfall at a
single institution can have system-wide
repercussions.
122. Risks Overall Interest Rate Risk?
- The interest rate risk of a bank resulting from
its global position. - Such a position is the result of aggregating all
the individual positions that a bank takes when
entering into transactions, whether on
balance-sheet (assets and liabilities) or
off-balance sheet. - Its management is sometimes associated with
managing liquidity, although the risks are not
the same.
132. Risks in Banking Operational risk
- An area of risk on which both banks and
supervisors are increasingly focusing because of
its relative importance. - No single definition available.
- Definition of New Basel Accord is partial risk
of loss resulting from inadequate or failed
internal processes, people and systems or from
external events. - The definition does include legal risk but
however does not include systemic risk,
strategic/business risk and reputational risk.
143. Risk factors Measurement of Credit Risk
- The basic measurement is empirical a loan is
supposedly priced according to how much risk it
involves. - The measurement of such risk implies assessing
the borrowers creditworthiness. - Three main components enter into the measurement
of credit risk size of exposure, default
probability of borrower and loss probability once
the borrower has defaulted. - When generalized to the whole bank, the
institution relate its economic capital for
credit risk to its portfolios probability
density function of credit losses
15Probability Density Function of Credit Losses
Economic capital
Frequency of loss
Stress loss
? Expected loss
Unexpected loss
0
Amount of loss
- Large number of small losses
- Few occasions with severe losses
163. Probability Density Function (PDF)
- Expected credit loss
- Amount of credit loss a bank expects to
experience on its credit portfolio over the
chosen time horizon - Ideally, provisions should cover expected losses
- Unexpected credit losses
- Amount by which actual losses exceed expected
loss - (Economic) capital should cover unexpected losses
- A risky portfolio is one whose PDF has a
relatively long and fat tail
173. Definition of Loss
- Credit loss arises only if a borrower defaults
- Inputs
- Default rates Obligors internal credit risk
rating - Default horizon Typically 1 year
- Exposure Exposure at default
- Recovery rate 1-recovery rate Loss-given
default - Correlations Correlation between credit losses
183. But what is a Default?
- Different definitions possible
- Firm is unlikely to pay its debt obligations
- Credit loss event associated with any other
obligation of the firm - Firm is past due more than 90 days (or more?)
- Firm has filed for bankruptcy or similar
protection
193. Probability of Default - Measurement
- Within most internal rating systems, key
criterion is internal credit risk rating - Bank establishes set of grades with specific
probability of default - Banks assign risk rating to each customer by
using - Financial and other characteristics of customer
- Vendor-supplied commercial credit scoring model
- Internally developed credit scoring model
- Often banks relate internal rating to external
rating standards - Bank places customer into predefined risk rating
category
203. Slotting of Loans into PD Grades
Loan A Loan B Loan C Loan D PD 0.02 PD
0.15 PD 0.68 PD 15
213. Time horizon for monitoring credit risk
- One-year horizon reflects the typical interval
over which e.g. - New capital could be raised
- Loss mitigation action could be taken
- Internal budgeting, capital planning and
accounting statements are prepared
223. Correlations between Credit Events
- Not all obligors will default at once
- But financial conditions of firms in the same
industry or within the same country may reflect
similar factors - Assessing such correlations is still quite
limited - The importance of such a risk has been
traditionally recognized in banking it is
closely related to risk concentration and
diversification of exposures - It has become more difficult to assess because
of globalization/inter-actions concentrations
can be to one borrower or related borrowers, one
sector or related sectors, one country or
geographical area.
234. Credit Risk management Guidance provided by
the Basel Committee
- Core Principles for Effective Banking Supervision
(1997) - Core Principles Methodology Paper (1999)
- Principles for the Management of Credit Risk
(2000)
244. Credit Risk Management
- Banks need to manage the credit risk inherent in
the entire portfolio as well as the risk in
individual credits or transactions - Banks should also consider the relationship
between credit risk and other risks - Sound credit risk management practices should be
applied in conjunction with sound practices
related to the assessment of asset quality, the
adequacy of provisions and reserves, and the
disclosure of credit risk
254. Credit Risk Management Process
- Establishing an appropriate credit risk
environment - Operating under a sound credit granting process
- Maintaining an appropriate credit administration
and monitoring process - Ensuring adequate controls over credit risk
- Role of Supervisors in the process.