Regulation   

Validation of Low-Default Portfolios in the Basel II Framework
Basel Committee Newsletter No.6, September 2005
Some banks hold portfolios that exhibit very low rates of default, or even no defaults at all, even over an extended period (e.g., portfolios of loans to sovereigns, banks, or highly rated corporations). This means that any straightforward probability of default calculation based on historic losses for a wholesale credit rating (or retail segment) will lack enough data points to be statistically reliable. Furthermore, any backtesting of the probability of default rates attached to ratings in the portfolio will not be easy. Some banks are concerned that the problem of validating any risk parameter estimates associated with low default portfolios might make it difficult for them to gain approval to apply Basel II's Internal Rating Based approach to calculating regulatory capital for these portfolios - potentially leading to higher capital charges. In this newsletter, the Basel Committee Accord Implementation Group's Validation Subgroup argues that low-default portfolios do not need to be treated as conceptually different to other portfolios, though they may require a special selection of techniques to enhance data richness, benchmarking and so on. 

Solutions for the Application of Basel II to Some Trading-Related Exposures and the Treatment of Double Default Effects
Basel Committee, 18 July 2005
This paper sets out capital requirements for banks' exposures to certain trading related activities, including counterparty credit risk. The paper also sets out how to treat the risk that both a borrower and a guarantor might default at the same time ("double default"). It supplements aspects of both the new Basel II rules, and the existing 1996 Market Risk Amendment.

The Ripple Effect: How Basel II Will Impact Institutions of All Sizes
ERisk, white paper, July 2005
This paper explores the impact that Basel II will have on all kinds of financial institutions, and discusses how Basel II investments in risk modeling and data gathering can be leveraged into ten key improvements in business management. The paper looks at how to overcome the key challenges of implementing Basel II, including improving the credit rating process, accurate risk factor estimation, sound approaches to operational risk, and the development of an overarching economic capital framework. It also sets out a seven-step route to the efficient implementation of Basel II that will allow banks to gain immediate business benefits from their longer-term investments in Basel II compliance programs.

A Model of Bank Capital, Lending and the MacroEconomy, Basel I versus Basel II
Lea Zicchino, Bank of England working paper no. 270, 2005
What will be the impact of the shift to the new Basel II capital adequacy rules on bank capital, lending and macroeconomic activity through the economic cycle? Under Basel II's Pillar I capital adequacy rules, a macroeconomic shock is likely to tighten capital constraints. While bank capital will likely be less variable under Basel II, bank lending may turn out to be more vulnerable to unexpected macroeconomic shocks. The paper notes, however, that under Pillar II of Basel II, banks may be told by regulators to hold more capital than the regulatory minimum as a protection against such economic downturns.

Guidance on the Estimation of Loss Given Default
Basel Committee, July 2005
Loss given default is one of the trickiest parameters to estimate when quantifying credit risk, and this challenge has taken on a new significance with the inclusion of an LGD parameter in Basel II’s internal rating based (IRB) approach to regulatory capital calculation. The final Basel II document told banks that LGD parameters had to "reflect economic downturn conditions where necessary". This paper is the outcome of a working group set up to see how banks could put this stricture into practice. The working group found that variation in LGD during times of high default rates could well be a material source of unexpected losses in some portfolios - but also that data limitations and a lack of consensus in the industry about analytical methodology made it difficult to specify a single approach to the problem. "The extent and manner by which potential dependencies between default rates and recovery rates are reflected in internal economic capital models varies considerably across institutions", the working group found. As a result, the working group determined that a principles-based approach to solving the problem with regard to Basel II implementation would be better than detailed rules, and this paper sets out this approach. 

Credit Ratings and the Standardized Approach to Credit Risk in Basel II
Patrick van Roy, European Central Bank, working paper series, August 2005
This paper takes a look at whether European banks that adopt the standardized approach to credit risk under Basel II might gain (or lose) a regulatory capital advantage by selecting different external credit rating agencies - given that ratings differ substantially across agencies. The paper finds that, though significant differences would arise from choosing particular agencies, these differences would not exceed 6-10% of the minimum capital requirement for loans to corporations, banks and sovereigns. On the whole, the paper finds that there may only be a limited incentive for banks to engage in this kind of regulatory arbitrage.

Switching Primary Federal Regulators: Is it Beneficial for U.S. Banks?
Richard J. Rosen, Economic Perspectives, Third Quarter, 2005
US commercial banks possess a degree of control over whether they will end up regulated by the Fed, the Office of the Comptroller of the Currency, or the Federal Deposit Insurance Company. This paper finds that over 10% of banks switched regulators during the period 1977-2003, and asks whether their ability to do so is a good or a bad thing in terms of trends in risk and return. The paper concludes that banks generally increase their return after they switch regulators – particularly in the most recent 1992-2003 period. On the risk side, it finds that banks tend to reduce their equity-to-asset ratio after a switch, but also that the bank failure rate of “switchers” does not seem to increase.

Studies on the Validation of Internal Rating Systems
BIS, May 2005
To take advantage of the internal rating based (IRB) approaches to calculating regulatory capital for credit risk under Basel II, banks will have to validate their rating systems. This lengthy publication looks at how banks and their regulators can go about this task. It has various sections on rating system validation, terminology and types of rating systems, validation of risk parameters (probability of default, loss given default and exposure at default), and on how to benchmark internal estimates against external estimates.

Credit Risk Transfer
Basel Committee, Joint Forum report, October 2004
This broad overview of the credit risk transfer market is partly based on interviews with market participants and offers various broad risk management recommendations to market participants and their regulators. It also offers a discussion on the key questions concerning the market: do credit risk transfer mechanisms actually transfer risk?; is the credit derivatives market too concentrated?; and do market participants themselves understand all the risks of participating? The report says that the most important credit risk management issue associated with CRT activity is probably the assessment of default correlation across different reference entities – and notes the emergence of “correlation trading desks” at the major CRT market intermediaries.

The New Basel Capital Accord and the Cyclical Behavior of Bank Capital
Mark Illing and Graydon Paulin, working paper, Bank of Canada, August 2004
What effect will the new Basel II rules have on the capital requirements of banks through the economic cycle? This paper applies the new rules to historic Canadian banking system data and finds that capital requirements may well fall, even after allowing for the operational risk charge. However, capital requirements may also increase during economic downturns as risk of default rises, a finding that raises again the question of whether Basel II might deter banks from lending during a recession and therefore act to aggravate rather than dampen the economic cycle (the so-called “pro-cyclicality” effect).

Assessing Commercial Real Estate Portfolio Risk
FDIC Supervisory Insights, 29 June 2004
Banking regulators in the United States are increasingly concerned about the growth of real estate exposure in US bank portfolios. This article takes a look at a pilot program for examining the real estate risk – and risk management practices – of banks in the Atlanta region. It finds that risk controls at banks have improved significantly since the 1990s (the last real-estate linked crisis in banking lending). However, the regulators did find problems at some banks including inadequate cash flow analysis; inconsistent compliance with regulatory loan-to-value guidelines; inadequate management information systems; miscoded loan data; and a lack of limits for aggregate speculative lending.

Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework
Basel Committee, 26 June 2004
This weighty document, the outcome of several years work by the Basel Committee and many banking industry working groups, represents the Basel II rules in their final form – or almost. While the contents of this “final” paper were agreed by all the Committee’s members, the rules remain subject to various impact studies, re-calibration, and a rolling process of clarification and implementation over the next few years.

Cyclical Implications of the Basel II Capital Standards
Anil Kashyap and Jeremy Stein, Federal Reserve Bank of Chicago, Economic Perspectives, 1^st Quarter 2004
This paper discusses whether the new Basel II risk-sensitive rules for bank regulatory capital might deepen the trough of future economic cycles. It suggests that Basel II might, indeed, have quite a large effect and looks at how regulators might link capital requirements to aggregate economic conditions to ease this potential failing. Suggestions range from relatively crude adjustment formulas (e.g., dropping the required ratio of capital to risk-weighted assets when GDP falls) to more sophisticated mechanisms such as a market for capital relief licenses.

Assessing Capital Adequacy in Relation to Risk at Large Banking Organizations and Others with Complex Risk Profiles
Federal Reserve Board SR 99-18, 1 July 1999
In July 1999, the Board of Governors of the Federal Reserve System issued this supervisory letter, which requires large or complex banking institutions to implement comprehensive capital adequacy frameworks. The intention was to make sure bank capital was not only adequate to meet formal minimum regulatory standards, but also fully sufficient to support all underlying risk positions. In particular, the letter requires qualifying banks to identify and measure all material risks, to relate their capital adequacy to their level of overall risk, to set out explicit capital adequacy goals and to assess conformity to institutional objectives. As the letter notes, while the banking industry may not quite have reached consensus on the best techniques for assessing capital adequacy, “sound practices are clearly moving toward a more quantitative, systematic and comprehensive process”.

ERisk Whitepaper - The Ripple Effect: How Basel II Will Impact Institutions of All Sizes
July 2005
Learn about the impact Basel II will have on financial institutions of all sizes and understand how your organization can leverage Basel II, overcome key challenges, and develop a practical roadmap for implementation.

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