Credit Risk in Australian Banks: Measuring Up to the Basel II StandardsThe 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; andwhether 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 ApproachThe 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.