Credit Risk in Australian Banks: Measuring Up to the Basel II Standards - Case Study Example

Credit Risk in Australian Banks: Measuring Up to the Basel II Standards The Two Approaches to Measuring Credit Risk The principles underlying sound measurement of credit risk are set forth in the “Principles for the Management of Credit Risk” issued by the Basel Committee in September 2000 and the factors they strongly recommend should be considered are: The reason for the credit and the source of the funds for repayment; the current risk profile of the borrower, counterparty, and collateral and how those might be affected by economic and market developments; the borrower’s repayment history and current ability to repay, taking into account past economic trends and the borrower’s future cash-flow prospects; for commercial loans, the borrower’s business record and qualifications, the economic conditions of the borrower’s business sector, and the business’ position within that sector; the terms and conditions of the credit, including provisions to prevent changes in the future risk profile of the borrower; and whether sufficient collateral or guarantees are needed, and if these are sufficiently enforceable. (BCBS1, 2000: 8-9) Under Basel II, the two methods by which banks can determine ‘the current risk profile’ are the Standardised Approach or the Internal Ratings-Based approach. The Standardised Approach The standardised approach is to be used by banks with less-complex credit exposures and those who do not do a significant amount of international business. According to the Basel II accord, this approach comprises a combination of risk profiling using internationally-accepted accounting standards and external credit assessments from rating agencies such as Fitch, Standard & Poor’s, or Moody’s. (Tri-Party Group, 2007) The main purpose of credit risk assessment from the point of view of the Basel Committee is to allow banks to maintain a proper level of capitalisation, which is defined as 8% of the value of risk-weighted assets, such as outstanding loans. (BCBS2, 2001: 3) The change from the previous accord to the updated version of June 2004 did not change the minimum capitalisation requirement, but expanded the risk weight categories; the ‘weight’ of a credit risk determines the calculation of its value against the capital requirement. For example, a risk weight of 100% means for that particular asset, 8% of its value would be added to the amount of capital needed by the bank; a risk weight of 50% would add 4% of the asset’s value to the calculation of minimum required capital. The risk weights under the standardised approach are to be drawn primarily from the external agencies. The rationale for expanding the categories in the 2004 revision is to make the calculations of capital requirements more risk-sensitive. (BCBS2, 2001: 3-4) The standardised approach has the advantage of being relatively simple and applicable to a wide range of circumstances and institutions. It has been criticised, however, on two points. First, the four risk categories (20%, 50%, 100%, and 150%) do not completely accurately reflect risk, as measured by the relationship of bond spreads to credit ratings; spreads increase as ratings decrease, but at a rate which is “steeper” than that accounted for by the Basel accord. (Resti & Sironi, 2005) For example, a large bond spread indicates a market sentiment of high risk, one that may be higher than the bond issuer’s credit rating indicates. Second, the standardised approach does not appear to work the same way for banks and non-financial institutions when the spread/rating relationship is examined. (Ibid.) In summary, it could be said that the standardised approach may not be an accurate way to assess risk for all types of institutions or in all circumstances. The Internal Ratings-Based Approach A partial answer to the applications that are not covered by the standardised approach is the internal ratings-based approach. In the internal ratings-based, or IRB, approach, the bank calculates a probability of default based on its own methods of assessing a borrower’s credit-worthiness. This calculation is combined with other factors which are either supplied by bank regulators – the ‘foundation’ method – or by the bank itself, if it has a “sufficiently developed capital allocation process” – the ‘advanced’ method – to determine capital requirements. (BCBS2, 2001: 4) In other words, the foundation method has predetermined factors for risk exposure and potential loss in case of default for banks to include in their calculations, while the advanced method allows banks to determine all these factors on their own, subject to approval of bank regulators, of course. (Teker, Akçay, and Bariş, 2003) In order for the IRB approach to function properly, banks are required to periodically review and test their internal ratings models, and bank regulators must ensure the systems being used by the banks are sound. (BCBS3, 2006: 6) There are at least two potential pitfalls in the IRB approach. First, a wide variation of standards can be applied, and these are only as good as the amount of detailed historical information about credit risk and performance that are input into the analyses. (Teker, Akçay, and Bariş, 2003) This can lead to situations in which banks with more stringent requirements are indirectly affected by the lending activities of others with less-demanding standards. One way in which this can happen is through ‘regulatory arbitrage’ where financial institutions engage in a sort of ‘forum-shopping’ to set up business in countries with less-strict regulations. (Tri-Party Group, 2007) Second, there is a large amount of faith implied in the IRB approach that bank managers and regulators will apply the appropriate standards and reviews of processes diligently. Lapses in oversight or in testing the effectiveness of ratings systems, or periods that are too long between reviews can mean that errors and bad judgment can occur. Even if these are caught and corrected, the damage may already be serious; one could surmise that this was partly responsible for the grave crisis in the U.S. that eventually affected the rest of the world. How Australian Banks Fare in relation to the Two Approaches The specific guidelines for the use of either the standardised approach or the internal ratings-based approach to determining credit risks by authorised deposit-taking institutions in Australia are set down in two standards issued by the Australian Prudential Regulation Authority. Australian Prudential Standard (APS) 112 details the requirements for the standardised approach, while APS 113 addresses the internal ratings-based approach. In both cases, of course, the primary objective is to set up a process by which the amount of necessary capitalisation can be determined and maintained. APS 112 is a bit simpler than APS 113, and its aim is “to ensure that an authorised deposit-taking institution using the standardised approach to credit risk applies a uniform approach to the measurement of its on-balance sheet assets and off-balance sheet credit exposures for regulatory capital purposes.” (APRA1, 2007: 1) It has two main conditions, the first being that assets and exposures must be risk-weighted, either by using external rating grades or another system of fixed weights based on the probability of default. The risk weight then leads to the calculation of the required capital, as described in the previous sections. The second condition of APS 112 provides for the capital requirement to be reduced if some approved, sound security such as collateral is provided for the asset or exposure. (APRA1, 2007: 1, 6) This provides banks and other financial institutions covered by APS 112 a small degree of flexibility in determining their capital requirements. All authorised deposit-taking institutions in Australia must use the standardised approach, with the exception of foreign ADI as defined by the Banking Act, and other institutions which have received APRA approval to use the internal ratings-based approach in accordance with APS 113. APS 113 details the requirements for ADIs to use an internal ratings-based approach in two ways, first as a matter of initially using the approach, and then as an ongoing monitoring of changing credit circumstances. Any ADI must have approval from APRA to use an IRB approach, and there are some requirements as to how some elements of risk must be assessed in order to calculate needed capital. (APRA2, 2007: 1, 4) An ADI may use the IRB approach for some assets and exposures and the standardised approach for others, under certain circumstances, but once it has been approved to use the IRB approach, it cannot revert to a fully-standardised approach without approval of APRA – something they describe as only likely to be granted in “exceptional circumstances” (APRA2, 2007: 3) – or if APRA determines the institution is not meeting the standard and orders it to change to a standardised approach. There are four credit risk components that must be measured: probability of default (PD), loss given default (LGD), exposure at default (EAD), and effective maturity (M), as well as the accounting components of expected losses (EL) and unexpected losses (UL). (APRA2, 2007: 4) the purpose of the calculations is to determine the amount of capital needed to protect the institution against unexpected losses (UL). For certain classes of assets, for example corporate loans, an ADI may use either a foundation (FIRB) approach or an advanced (AIRB) approach in the measurement of the components, subject to APRA approval. The difference between the two is that under an FIRB, the institution provides its own calculations of the PD and M factors, while “supervisory estimates” provide the values of the others. In an AIRB approach, the ADI supplies the values of all the risk components; in either case, the ADI must use risk-weight functions provided by the standard. (APRA2, 2007: 4) The impression one gets from all this in order to answer the question, “How do Australian banks stack up against these two approaches?” is that the regulatory guidelines are firm, detailed, and leave little room for imaginative management of credit risk or capitalisation on the part of the banks; thus the answers seems to be, “Very well indeed.” Whether or not the two approaches are being properly used and regulated should be apparent from the health of Australia’s banks – if the two approaches are effective, banks should be adequately capitalised and not facing a serious credit crisis. According to the most-recent (March 2009) available Financial Stability Review from the Reserve Bank of Australia, the Australian banking system is in reasonably sound shape, especially when compared to the troubles in other major banking systems around the world. The FSR points out that although bank profits are lower, they are still profits and not losses, and that the banks do have the proper levels of capital, which gives them the advantage of high credit ratings. The FSR also explains that Australian banks had not obtained large amounts of the sort of high-risk securities that caused problems in countries such as the US, and that compared to banks in other countries, Australian banks did not relax their credit standards quite as much. This last advantage could be directly attributed to the good management of the credit risk assessment approaches by the banking system and APRA. To be fair, there have been some positive outside influences that have helped the banks. Government stimulus programs have provided guarantees for some debts, and because of the economic downturn, demand for credit has declined considerably; businesses are not seeking new loans, and households are similarly reducing their spending and debts and saving more. (RBA, 2009) Nevertheless, these factors would probably not be helping the banks so much, if at all, if the careful application and regulation of the credit risk assessment approaches were not followed in the first place. While there are valid criticisms and refinements that could likely be made to the standardised and internal ratings-based approaches, on the whole they seem to have worked as intended for Australia’s banks. Works Cited Australian Prudential Regulation Authority [APRA]1. (2007) “Prudential Standard APS 112 – Capital Adequacy: Standardised Approach to Credit Risk”. [Internet] APRA, June 2007. Available from: . Australian Prudential Regulation Authority [APRA]2. (2007) “Prudential Standard APS 113 – Capital Adequacy: Internal Ratings-based Approach to Credit Risk”. [Internet] APRA, June 2007. Available from: . Basel Committee on Banking Supervision [BCBS]1. (2000) “Principles for the Management of Credit Risk”. [Internet] BCBS, September 2000. Available from: . Basel Committee on Banking Supervision [BCBS]2. (2001) “The New Basel Capital Accord: an explanatory note”. [Internet] BCBS, January 2001. Available from: . Basel Committee on Banking Supervision [BCBS]3. (2006) “Sound credit risk assessment and valuation for loans”. [Internet] BCBS, June 2006. Available from: . Reserve Bank of Australia [RBA]. (2009) “Financial Stability Review – March 2009”. [Internet] RBA, March 2009. Available from: Resti, Andrea, and Sironi, Andrea. (2005) “The Basel Committee Approach to risk – weights and external ratings: what do we learn from bond spreads?” [Internet] Banca d’Italia, February 2005. Available from: . Teker, Suat, Akçay, Bariş, and Turan, Mustafa. (2003) “Measuring Credit Risk of a Bank's Corporate Loan Portfolio Using Advanced Internal Ratings Base Approach”. [Internet] International Economics Conference, Ankara, 2003. Available from: . Tri-Party Group [Guernsey Financial Services Commission, Isle of Man Financial Supervision Commission, Jersey Financial Services Commission]. (2007) “Basel II – Credit Risk”. [Internet] Tri-Party Group, October 2007. Available from: . Read More