Lecture – 7 Credit Risk-Basel Accords

Learning Outcomes
• Credit Risk Management

• Traditional Models of Credit Risk Analysis

• Capital Adequacy Ratio

• Reasons for Bank Regulation

• Bank Regulation Pre 1988

• Basel 1

• Basel 2
 What is credit risk
• Credit risk refers to the risk that a borrower may not repay a
loan and that the lender may lose the principal of the loan or
the interest associated with it.

• Credit risk arises because borrowers expect to use future cash

flows to pay current debts; it's almost never possible to
ensure that borrowers will definitely have the funds to repay
their debts.

• Interest payments from the borrower or issuer of a debt

obligation are a lender's or investor's reward for assuming
credit risk.
 Traditional models of credit risk analysis
• (1) expert systems

• (2) Credit rating systems, including bank internal rating

systems; and
•
• (3) credit scoring systems.
 EXPERT SYSTEMS
• In an expert system, the credit decision is left to the local
or branch lending officer or relationship manager

• Implicitly, this person’s expertise, subjective judgment,

and weighting of certain key factors are the most
important determinants in the decision to grant credit.

• one of the most common expert systems—the five “Cs”

of credit analyzes five key factors
 Five Cs of Credit Analysis
• 1. Character. A measure of the reputation of the firm, its
willingness to repay, and its repayment history. In particular,
it has been established empirically that the age of a firm is a
good proxy for its repayment reputation.

• 2. Capital. The equity contribution of owners and its ratio

to debt (leverage). These are viewed as good predictors of
bankruptcy probability. High leverage suggests a greater
probability of bankruptcy.

• 3. Capacity. The ability to repay, which reflects the volatility

of the borrower’s earnings. If repayments on debt contracts
follow a constant stream over time, but earnings are volatile
(or have a high standard deviation), there may be periods
when the firm’s capacity to repay debt claims is constrained
 Five Cs of Credit Analysis
• 4. Collateral. In the event of default, a banker has
claims on the collateral pledged by the borrower. The
greater the priority of this claim and the greater the
market value of the underlying collateral, the lower the
exposure risk of the loan

• 5. Cycle (or Economic) Conditions. The state of the

business cycle; an important element in determining
credit risk exposure, especially for cycle-dependent
industries.
 Problems in Expert systems
• Although many banks still use expert systems as part of
their credit decision process, these systems face two main
problems:
• Consistency. What are the important common factors to
analyze across different types of customers.

• Subjectivity. What are the optimal weights to apply to

the factors chosen.

• Dispersion in accuracy across 43 loan officers evaluating

60 loans: accuracy rate ranged from 27-50. Libby (1975),
Libby, Trotman & Zimmer (1987
 Problems in Expert systems
• Quite different standards can be applied by credit
officers, within any given bank or FI, to similar types of
borrowers.

• This disparity in ability across experts has led to the

development of computerized expert systems, such as
credit rating systems, that attempt to incorporate the
knowledge of the best human experts.
 CREDIT SCORING SYSTEMs
• Pre-identify certain key factors that determine the
probability of default (as opposed to repayment), and
combine or weight them into a quantitative score

• The score can be used as a classification system: it places

a potential borrower into either a good or a bad group,
based on a score and a cut-off point.
• Full reviews of the traditional approach to credit
scoring, and the various methodologies, can be found in
Caouette, Altman, and Narayanan (1998) and Saunders
(1997).
• A good review of the worldwide application of credit-
scoring models can be found in Altman and Narayanan
(1997).
 Altman- Z score
• One of the oldest credit scoring model is the Altman-Z
model developed by Altman
• Customers who have a Z-score below a critical value (in
Altman’s initial study, 1.81), they would be classified as
“bad” and the loan would be refused.
 What is Capital Adequacy Ratio
• Percentage ratio of a financial institution's primary capital to its assets
(loans and investments), used as a measure of its financial strength and
stability.

• The capital adequacy ratio (CAR) is a measure of a bank's capital. It is

expressed as a percentage of a bank's risk weighted credit exposures

• Capital Adequacy Standard set by Bank for International Settlements

(BIS),

• Banks must have a primary capital base equal at least to eight percent of
their assets: a bank that lends 12 dollars for every dollar of its capital is
within the prescribed limits.
•
 CAR

• Tier one capital is the capital that is permanently and easily

available to cushion losses suffered by a bank without it being
required to stop operating. A good example of a bank’s tier
one capital is its ordinary share capital.

• Tier two capital is the one that cushions losses in case the
bank is winding up, so it provides a lesser degree of
protection to depositors and creditors. It is used to absorb
losses if a bank loses all its tier one capital.
 CAR
• When measuring credit exposures, adjustments are made
to the value of assets listed on a lender’s balance sheet.
All the loans the bank has issued are weighted based on
their degree of risk. For example, loans issued to the
government are weighted at 0 percent, while those given
to individuals are assigned a weighted score of 100
percent.
 THE REASONS FOR REGULATING BANKS
• To ensure that a bank keeps enough capital for the risks it
takes.

• Not possible to eliminate altogether the possibility of a bank

failing, but governments want to make the probability.

• By doing this, they hope to create a stable economic

environment where private individuals and businesses have
confidence in the banking system.

• A major concern of governments is what is known as systemic

risk. This is the risk that a failure by a large bank will lead to
failures by other large banks and a collapse of the financial
system.
 BANK REGULATION PRE-1988
• Prior to 1988, bank regulators within a country tended
to regulate bank capital by setting minimum levels for
the ratio of capital to total assets.

• Some countries enforced their regulations more

diligently than other

• The huge exposures created by loans from the major

international banks to less developed countries such as
Mexico, Brazil, and Argentina
 BANK REGULATION PRE-1988
• A more sophisticated approach than that of setting
minimum levels for the ratio of capital to total balance-
sheet assets was needed.

• The Basel Committee was formed in 1974.

• The first major result of these meetings was a document

entitled
• “International Convergence of Capital Measurement and
Capital Standards.” This was referred to as “The 1988
BIS Accord” or just “The Accord.” More recently, it has
come to be known as Basel I.
 THE 1988 BIS ACCORD
• The 1988 BIS Accord was the first attempt to set
international risk-based standards for capital adequacy.

• It was signed by all 12 members of the Basel Committee

and paved the way for significant increases in the
resources banks devote to measuring, understanding, and
managing risks.

• Requirement involved what is known as the Cooke ratio

 The Cooke Ratio
• In calculating the Cooke ratio, both on-balance-sheet and
off-balance-sheet items are considered.
• They are used to calculate what is known as the bank’s
total riskweighted assets (also sometimes referred to as the
risk-weighted amount).
• This is a measure of the bank’s total credit exposure.

• where Li is the principal amount of the ith item and wi

is its risk weight
 Example
• The assets of a bank consist of $100 million of
corporate loans, $10 million of OECD government
bonds, and $50 million of uninsured residential
mortgages. The total risk-weighted assets is?
 Capital Requirement
• The Accord required banks to keep capital equal to at
least 8% of the risk-weighted assets. The capital had two
components:

• Tier 1 Capital. This consists of items such as equity and

non-cumulative perpetual preferred stock3. (Goodwill is
subtracted from equity.)
• Tier 2 Capital. This is sometimes referred to as
supplementary capital. It includes instruments such as
cumulative perpetual preferred stock,4 certain types of
99-year debenture issues, and subordinated debt with an
original life of more than five years.
• Equity capital is important because it absorbs losses.
Other types of capital are important because they are
subordinate and therefore provide a cushion that protects
depositors in the event of a failure by the bank.

• The Accord required at least 50% of the required capital

to be in Tier 1.
• The bank supervisors in some countries require banks to
hold more capital than the minimum specified by the
Basel Committee and some banks themselves have a
target for the capital they will hold that is higher than
that specified by their bank supervisors.
 BASEL II
• The 1988 Basel Accord improved the way capital
requirements were determined, but it does have
significant weaknesses.
• Under the 1988 Basel Accord, all loans by a bank to a
corporation have a risk weight of 100% and require the
same amount of capital. A loan to a corporation with a
AAA credit rating is treated in the same way as one to a
corporation with a B credit rating

• In June 1999, the Basel Committee proposed new rules

that have become known as Basel II. These were revised
in January 2001 and April 2003.
 Pillars
• The Basel II is based on three “pillars”:

• 1. Minimum Capital Requirements

• 2. Supervisory Review
• 3. Market Discipline

• The general requirement in Basel I that banks hold a

total capital equal to 8% of risk-weighted assets (RWA)
remains unchanged.
 Pillars

• Pillar 2, which is concerned with the supervisory review

process, Supervisors are required to do far more than just
ensuring that the minimum capital required under Basel II is
held. Part of their role is to encourage banks to develop and
use better risk management techniques and to evaluate these
techniques.
• The third pillar, market discipline, requires banks to disclose
more information about the way they allocate capital and the
risks they take. The idea here is that banks will be subjected
to added pressure to make sound risk management decisions
if shareholders and potential shareholders have more
information about those decisions.
 Pillar 2
• 1. Banks should have a process for assessing their overall capital
adequacy in relation to their risk profile and a strategy for maintaining
their capital levels.

• 2. Supervisors should review and evaluate banks’ internal capital

adequacy assessments and strategies, as well as their ability to monitor
and ensure compliance with regulatory capital ratios. Supervisors should
take appropriate supervisory action if they are not satisfied with the
result of this process.

• 3. Supervisors should expect banks to operate above the minimum

regulatory capital and should have the ability to require banks to hold
capital in excess of this minimum.

• 4. Supervisors should seek to intervene at an early stage to prevent

capital from falling below the minimum levels required to support the
risk characteristics of a particular bank and should require rapid
remedial action if capital is not maintained or restored.
 Pillar 3
• 1. The entities in the banking group to which Basel II is
applied and adjustments made for entities to which it is not
applied
• 2. The terms and conditions of the main features of all
capital instruments
• 3. A list of the instruments constituting Tier 1 capital and
the amount of capital provided by each item
• 4. The total amount of Tier 2 capital.
• 5. Capital requirements for credit, market, and operational
risk
• 6. Other general information on the risks to which a bank is
exposed and the assessment methods used by the bank for
different categories of risk.
• 7. The structure of the risk management function and how it
operates.
 CREDIT RISK CAPITAL UNDER BASEL II
• For credit risk, Basel II specified three approaches

• 1. The Standardized Approach

• 2. The Foundation Internal Ratings Based (IRB)

Approach

• 3. The Advanced IRB Approach

 The Standardized Approach
• The standardized approach is used by banks that are not
sufficiently sophisticated (in the eyes of the regulators)
to use the internal ratings approaches.
 CAMELS rating system
• The CAMELS rating system is a recognized
international rating system that bank supervisory
authorities use in order to rate financial institutions
according to six factors represented by the acronym
"CAMELS." Supervisory authorities assign each bank a
score on a scale, and a rating of one is considered the
best and the rating of five is considered the worst for
each factor.
 CAMELS rating system
• Capital Adequacy

• Asset Quality

• Management

• Earnings

• Liquidity

• Sensitivity
 CAMELS rating system
• Rating 1
– Indicates strong performance and risk management practices
that consistently provide for safe and sound operations.
Management clearly identifies all risks and employs
compensating factors mitigating concerns. The historical trend
and projections for key performance measures are consistently
positive.
• Rating 2
– Reflects satisfactory performance and risk management
practices that consistently provide for safe and sound
operations. Management identifies most risks and compensates
accordingly. Both historical and projected key performance
measures should generally be positive with any exceptions
being those that do not directly affect safe and sound
operations. Banks and credit unions in this group are stable and
able to withstand business fluctuations quite well; however,
minor areas of weakness may be present which could develop
into conditions of greater concern.
 CAMELS rating system
• Rating 3
• Represents performance that is flawed to some degree and is of
supervisory concern. Risk management practices may be less than
satisfactory relative to the bank's or credit union's size, complexity,
and risk profile. Management may not identify and provide
mitigation of significant risks. Both historical and projected key
performance measures may generally be flat or negative to the
extent that safe and sound operations may be adversely affected.
Banks and credit unions in this group are only nominally resistant
to the onset of adverse business conditions and could easily
deteriorate if concerted action is not effective in correcting certain
identifiable areas of weakness. Overall strength and financial
capacity is present so as to make failure only a remote probability.
These banks and credit unions may be in significant
noncompliance with laws and regulations. Management may lack
the ability or willingness to effectively address weaknesses within
appropriate time frames. Such banks and credit unions require
more than normal supervisory attention to address deficiencies.
 CAMELS rating system
• Rating 4
• Refers to poor performance that is of serious
supervisory concern. Risk management practices are
generally unacceptable relative to the bank's or credit
union's size, complexity and risk profile. Key
performance measures are likely to be negative. Such
performance, if left unchecked, would be expected to
lead to conditions that could threaten the viability of the
bank or credit union. There may be significant
noncompliance with laws and regulations. The board of
directors and management are not satisfactorily
resolving the weaknesses and problems. A high potential
for failure is present but is not yet imminent or
pronounced. Banks and credit unions in this group
require close supervisory attention.
 CAMELS rating system
• Rating 5
• Considered unsatisfactory performance that is critically
deficient and in need of immediate remedial attention.
Such performance, by itself or in combination with other
weaknesses, directly threatens the viability of the bank
or credit union. The volume and severity of problems
are beyond management's ability or willingness to
control or correct. Banks and credit unions in this group
have a high probability of failure and will likely require
liquidation and the payoff of shareholders, or some other
form of emergency assistance, merger, or acquisition.
• Debt Instrument Rating Methodology Document.pdf
 Example
• Suppose that the assets of a bank consist of $100 million
of loans to corporations rated A, $10 million of
government bonds rated AAA, and $50 million of
residential mortgages. Under the Basel II standardized
approach, the total risk-weighted assets is?