Basel Capital Accord Research Articles

Corporate Credit Risk Modeling: Quantitative Rating System and Probability of Default Estimation

Research on corporate credit risk modeling for privately-held firms is limited, although these firms represent a large fraction of the corporate sector worldwide. Research in this area has been limited because of the lack of public data. This study is an empirical application of credit scoring and rating techniques to a unique dataset on private firms bank loans of a Portuguese bank. Several alternative scoring methodologies are presented, validated and compared. Furthermore, two distinct strategies for grouping the individual scores into rating classes are developed. Finally, the regulatory capital requirements under the New Basel Capital Accord are calculated for a simulated portfolio, and compared to the capital requirements under the current regulation.

Credit Risk Models and Agricultural Lending

AbstractCredit risk models are developed and used to estimate capital requirements for agricultural lenders under the New Basel Capital Accord. The study uses credit value‐at‐risk methods to calculate probability of default, loss given default, and expected and unexpected losses. Two applied models, CreditMetrics and Moody's KMV, are estimated using farm financial data. The results show that the necessary capital for agricultural lenders under the New Basel Accord varies substantially depending on the riskiness and granularity of the portfolio.

Modeling Credit Risk for SMEs: Evidence from the US Market

Considering the fundamental role played by small and medium sized enterprises (SMEs) in the economy of many countries and the considerable attention placed on SMEs in the new Basel Capital Accord, we develop a distress prediction model specifically for the SME sector and to analyze its effectiveness compared to a generic corporate model. The behavior of financial measures for SMEs is analyzed and the most significant variables in predicting the entities' credit worthiness are selected in order to construct a default prediction model. Using a logit regression technique on a panel of over 2,000 US firms (with sales less than $65 million) over the period 1994-2002, we develop a one-year default prediction model. This model has an out of sample prediction power which is almost 30% higher than a generic corporate model. An associated objective is to observe our model's ability to lower bank capital requirements considering the new Basel Capital Accord's rules for SMEs.

Bank Size and Risk-Taking under Basel II

This paper discusses the relationship between bank size and risk-taking under Pillar I of the New Basel Capital Accord. Using a model with imperfect competition and moral hazard, we find that small banks (and hence small borrowers) may profit from the introduction of an internal ratings based (IRB) approach if this approach is applied uniformly across banks. However, the banks' right to choose between the standardized and the IRB approaches unambiguously hurts small banks, and pushes them towards higher risk-taking due to fiercer competition. This may even lead to higher aggregate risk in the economy.

Basel 2: Developing countries and portfolio diversification

The proposed new Basel Capital Accord aims to better align regulatory capital with the risk that banks actually take on. This paper argues that current proposals will inappropriately and significantly increase the cost or reduce the quantity of bank lending to developing countries, as they will make the requirements for lending to them far more stringent. The failure of the Basel proposals to take account of the benefits of international diversification implies that risk is overestimated at the portfolio level. We show that, for a number of variables (such as bank profitability) and for a number of periods, the degree of correlation between developed economies is greater than that between developed and developing countries. We also show via simulations that a portfolio diversified across developed and developing economies has a lower level of risk than one focused only on developed ones. We therefore urge the Basel committee to explicitly incorporate the clear benefits of international diversification.

Risk‐based capital requirements and their impact upon the banking industry: Basel II and CAD III

The Basel Committee has proposed a new capital framework to respond to the deficiencies of the 1988 Capital Accord (Basel I). The 1988 Accord has been criticised for its crude assessment of risk and for creating opportunities for regulatory arbitrage. In principle, the new approach, often referred to as Basel II, is not intended to raise or lower the overall level of regulatory capital currently held by banks, but to make it more risk sensitive. The spirit of the new Accord is to encourage the use of internal systems for measuring risks and allocating capital (the Accord extends the use of internal models from market risk to credit risk). A number of issues have been raised, however, with regard to its complexity, its cost, its impact on procyclicality, the possibility that it can lead to competitive distortions if some countries do not apply it (some big emerging economies) or apply it differently to small and big institutions (the USA) and others. Banks in Europe will also be obliged to comply with the new Capital Directive, often referred to as CAD III, which is the means by which the EU will implement the new Basel Capital Accord. CAD III will apply to all credit institutions and investment firms and not only to internationally active banks, as Basel does. This paper presents a critical approach to these developments and examines their impact upon the banking industry.

Modelling Operational Losses: A Bayesian Approach

AbstractThe exposure of banks to operational risk has increased in recent years. The Basel Committee on Banking Supervision (known as Basel II) has established a capital charge to cover operational risks other than credit and market risk. According to the advanced methods defined in ‘The New Basel Capital Accord’ to quantify the capital charge, in this paper we present an advanced measurement approach based on a Bayesian network model that estimates an internal measure of risk of the bank. One of the main problems faced when measuring the operational risk is the scarcity of loss data. The methodology proposed solves this critical point because it allows a coherent integration, via Bayes' theorem, of different sources of information, such as internal and external data, and the opinions of ‘experts’ (process owners) about the frequency and the severity of each loss event. Furthermore, the model corrects the losses distribution by considering the eventual relations between different nodes of the network that represent the losses of each combination of business line/event type/bank/process and the effectiveness of the corresponding internal and external controls. The operational risk capital charge is quantified by multiplying the value at risk (VaR) per event, a percentile of the losses distribution determined, by an estimate of the number of losses that may occur in a given period. Furthermore, it becomes possible to monitor the effectiveness of the internal and external system controls in place at the bank. The methodology we present has been experimented as a pilot project in one of the most important Italian banking groups, Monte dei Paschi di Siena. Copyright © 2004 John Wiley & Sons, Ltd.

An empirical comparison of default risk forecasts from alternative credit rating philosophies

The New Basel Capital Accord will allow the determination of banks' regulatory capital requirements due to probabilities of default (PDs) which are estimated and forecasted from internal ratings. Broadly, two rating philosophies are distinguished: through the cycle versus point in time ratings. We employ a likelihood ratio backtesting of both types with respect to their probability of default forecasts and correlations derived from a nonlinear random effects panel model using data from Standard & Poor's. The implications for risk capital using these different philosophies are demonstrated. It is shown that Point in Time Ratings will exhibit much lower correlations and, thus, default probability forecasts should be more precise. As a consequence, Value-at-Risk quantiles of default distributions should be lower than those generated by Through the Cycle Ratings. Nevertheless, banks which use Point in Time Ratings may be punished in times of economic stress if the implied reduction of asset correlation is not taken into account.

Unificando a alocação de capital em bancos e seguradoras no Brasil

Um dos motivos para a recente evolução da gestão de riscos em bancos internacionais é a proposta contida no Novo Acordo de Capital da Basiléia. Essa proposta busca uma maior especialização na alocação de capital em função dos riscos presentes nas atividades dos bancos, tendência que já vem sendo refletida no ambiente regulamentar local pelo Banco Central do Brasil. A gestão de riscos e a alocação de capital em seguradoras no mercado internacional encontram-se em um processo de convergência acelerada para os princípios requeridos dos bancos. O mesmo não pode ser dito no que se refere ao ambiente regulamentar para as seguradoras no Brasil, que ainda se encontra em um estágio de desenvolvimento inferior quando comparado a seu equivalente local para bancos. Neste ensaio, apresentamos as diferenças existentes entre os ambientes de requerimento regulamentar de capital para bancos e seguradoras no Brasil. Nosso objetivo é propor a unificação desses ambientes no mercado brasileiro, apresentando uma sugestão de como tal unificação deve ser conduzida.

The Basel Capital Accords and International Mortgage Markets: A Survey of the Literature

This paper surveys the literature on the impacts of the Basel Capital Accords on banking market profitability, competitiveness, structure and risk‐taking. Special emphasis is applied to the evolution of mortgage markets throughout the world over almost two decades of international bank regulatory policies.

Two New Measures of Bankruptcy Efficiency

This study is aimed at developing new empirical models for evaluating the efficiency of bankruptcy legislations. The paper is divided in three parts. In the first part, we analyze from a conceptual point of view the effects on debtor firms of the lack of creditors' powers in bankruptcy. In the second part, we develop a new rating method for bankruptcy legislations according to their degree of creditors protection and apply it to five European countries. In the third part, we introduce a new approach for empirically estimating the efficiency of bankruptcy legislation based on the cost of banking credit and we test it on the Italian case. In particular, the unprecedented tool being used in the third section consists of the New Basel Capital Accord, i.e. the capital adequacy regulatory framework that is about to be put into effect as of the end of 2006.

The New Basel Capital Accord: Part II: Technology Risks for Banks and the Role of Insurance

In Part I of this article, we examined the scope of the new Basel Capital Accord, or Basel II, its introduction of “operational risk” in a bank's risk-to-capital equation, and its implicit inclusio...

The New Basel Capitol Accord: Is 8% Adequate?

The 1988 Basel Accord established 8% of risk weighted assets as the minimum equity capital standard that reflected bank risks at that time. The New Basel Capital Accord, to be implemented in 2006, maintains the 8% equity capital as the minimum standard, and it changes with the way the capital standard is computed in order to take certain risks into account. Nevertheless, this article argues that it does not reflect the higher degree of risks that banks face today. These risks include more off-balance sheet derivatives, real estate loans, subprime loans and over-exposure to equities. Because of the increased risks, a higher equity capital ratio is needed.

Bayesian Multi-Period Model for Assessing Credit Loss Distributions vs. Basel II Model

The New Basel Capital Accord (Basel II) developed by the Basel Committee on Banking Supervision establishes new procedures for assessing a credit risk and capital adequacy requirements. For corporate client Basel II model suggests that a bank and its supervisor determine four parameters and substitute them in formulae represented in the model to calculate required capital and risk-weighted assets. Three of four parameters - Maturity, Loss Given Default, Exposure at Default - are characteristics of loan and only one - Probability of a client's default within one year (PD) - is characteristic of a borrower. It is interesting to know whether the single parameter PD (and rules of its processing) can fully and adequately describe defaulting borrower and his inherent risk. To answer this question the current paper develops an alternative Bayesian Multi-period (BMP) model that much more closely traces financial process of lending and its risks. The alternative model has the same output as the Basel II model and quite natural inputs. Both models were tested on the same input data; it was found that their outputs drastically differ from each other. Natural conclusion is that the only parameter PD in Basel II is insufficient characteristic of corporate client's risk. Furthermore, detailed analysis excites strong suspicion that errors are present in mathematical inference of principal Basel II formulae, related to credit risk. Being improved the formulae become much more simple, transparent and to some degree trivial. Some parameters like Probability of Default, Maturity Adjustment need to be redefined while others, like Correlation, appear to be irrelevant within current Basel II model. The Bayesian Multi-period model is proposed as the alternative to the current BaseI II model.

Dealing with Basel II: the impact of the New Basel Capital Accord

International regulators are due to finalize the New Basel Capital Accord by the end of 2003, for implementation by banks at the end of 2006. Basel II is a response to the need for reform of the regulatory system governing the global banking industry. In this article, we review the New Basel Capital Accord and summarize some of the main implications that we expect it to have on the European banking industry. As was the case for the first Basel Accord (Basel I), we conclude that not only will the new accord have an impact on the amount of book capital that banks are required to hold, but also on the strategic landscape of the banking industry.

Market Discipline: Is it Fact or Fiction?

The Bank for International Settlements (BIS) is an international organization that fosters cooperation among central banks and other agencies in pursuit of monetary and financial stability. The Basel Committee on Banking Supervision, which is part of the BIS, issued a proposal for a New Basel Capital Accord that is to be implemented by participating banks throughout the world in 2006. The New Capital Accord is based, in part, on market discipline. This article examines what market discipline means, the requirements for market discipline, and its effectiveness. The conclusion is that market discipline is a good idea, but it has not been effective in the recent past.

Private Actors and Public Policy: A Requiem for the New Basel Capital Accord

After the Asian crisis of 1997-98, policy-makers invested much energy in designing a new international financial architecture. However, many of the policy proposals that have emerged from think tanks and the multilateral agencies have proven unworkable or politically unpalatable. The debate focuses on state-led initiatives. But the assumption that public policy is by definition an output of public institutions is difficult to sustain in an era of global change. This article considers specialized forms of intelligence gathering and judgment determination which seem increasingly important as sources of governance in this era of financial market volatility: Moody's Investors Service and Standard & Poor's, the major bond rating agencies. More specifically, we examine a proposal of the Basel Committee on Banking Supervision to reform the existing capital adequacy framework by incorporating banks' own internal ratings and external bond ratings from the rating agencies, in order to calculate bank risk-weighted capital requirements. The article identifies a series of negative implications from the use of private rating agencies as a substitute for state-based regulation, premised on the organizational incentives that shape the ratings industry. Cementing these organizational incentives into the emerging financial architecture will, we argue, lead to negative social and economic consequences.

The New Basel Capital Accord and its Impact on Small and Medium-sized Companies

The New Basel Capital Accord and its Impact on Small and Medium-sized Companies

Operational Risk in Financial Service Providers and the Proposed Basel Capital Accord: An Overview

The 1988 Basel Accord and the proposed revisions to the Accord represent some of the most significant international regulations impacting the financial decisions of firms, in this case, financial services firms, in recent years. The revisions to the Accord incorporate operational risk into the capital, supervisory and market requirements. In our review of the issues in this area, we provide insight into the workings of an important international regulation. We also present suggestions for further research in this area that will become feasible when data on the impact of the new regulations become available after the proposed implementation in 2006.

The bank approach to a credit obligor - a farm business - in the context of credit risk and capital adequacy

The objective of this paper is to enable a bank’s view towards a credit obligor. Banks are subject to a lot of financial risks. Credit risk is the most important one. Banks also have to manage the objective of maximum profit on one hand, the prudential rules on the other hand. Recently, the Bank for International Settlements submitted a new concept of prudential rules (The New Basel Capital Accord) that should be accepted by national regulators and applied from 2006/7. This concept brings relatively strict conditions which should improve bank management of credit risk but which are unpleasant for loaning of small and medium enterprises including agricultural ones that are mostly part of this category. Very important role will be still played by non-market supporting instruments, especially guarantees provided by sovereigns. They can improve the competitiveness of agricultural enterprises in the credit market.