The Basel II Reform and Retail Credit Markets

Abstract

Over the last two decades, many large banks have developed advanced quantitative credit risk models for allocating economic capital, measuring risk-adjusted returns at the businessline and individual credit level, and improving overall risk management. The advent of these new models and their incorporation into bank credit risk management were an important impetus for the effort to reform the Basel Committee’s standards for regulatory capitalV Basel IIVand, in turn, the Basel II proposal is encouraging banks to upgrade their credit risk management approaches. Under the Basel II proposal, banks with sufficiently sophisticated risk measurement and management systems can use their own internal systems to estimate key risk parameters that determine regulatory capital minimums. While general principles of portfolio credit risk modeling are applicable for commercial and retail portfolios, the Basel II framework was built based primarily on industry practices developed for large commercial credits. Over time, the Basel II proposal has explicitly incorporated the unique characteristics of retail credits into this overall framework. The Basel II proposal defines retail loans to include most loans to individuals, including credit card loans, mortgage loans, home equity lines of credit, auto loans, and other consumer loans. In addition, the Basel II proposal includes small loans to businesses as retail credits if those loans are managed on a pooled basis. Basel II’s initial emphasis on corporate credit is not entirely surprising, since many of the models built for estimating capital needs and extreme tails of credit loss distributions (e.g., CreditMetrics, Credit Risk, KMV Portfolio Manager) were explicitly developed for the large commercial bond or loan sector. Moreover, much of the academic research on credit risk also focused on the large corporate credit market where data were more easily available