Credit Risk

There is always uncertainty in a counterparty's ability to meet its obligations.

While banks and financial institutions have faced difficulties over the years for many reasons, the major cause of serious banking problems continues to be directly related to lax credit standards for borrowers and counterparties, poor portfolio risk management, or a lack of attention to changes in economic or other circumstances that can lead to a deterioration in the credit standing of a bank's counterparties.

This experience is common in both G-20 and non-G-20 countries.

Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms.

The goal of credit risk management is to maximise a bank's risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters.

Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions.

Banks should also consider the relationships between credit risk and other risks.

The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any banking organisation.

For most banks, loans are the largest and most obvious source of credit risk; however, other sources of credit risk exist throughout the activities of a bank, including in the banking book and in the trading book, and both on and off the balance sheet.

Banks are increasingly facing credit risk (or counterparty risk) in various financial instruments other than loans, including acceptances, interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transactions.

Since exposure to credit risk continues to be the leading source of problems in banks world-wide, banks and their supervisors should be able to draw useful lessons from past experiences.

Banks should now have a keen awareness of the need to identify, measure, monitor and control credit risk as well as to determine that they hold adequate capital against these risks and that they are adequately compensated for risks incurred.

The Basel Committee is encouraging banking supervisors globally to promote sound practices for managing credit risk.

Although the Basel principles are most clearly applicable to the business of lending, they should be applied to all activities where credit risk is present.

The sound practices specifically address the following areas:

(i) establishing an appropriate credit risk environment.

(ii) operating under a sound credit-granting process.

(iii) maintaining an appropriate credit administration, measurement and monitoring process.

(iv) ensuring adequate controls over credit risk.

Although specific credit risk management practices may differ among banks depending upon the nature and complexity of their credit activities, a comprehensive credit risk management program will address these four areas.

These practices should also be applied in conjunction with sound practices related to the assessment of asset quality, the adequacy of provisions and reserves, and the disclosure of credit risk, all of which have been addressed in Basel Committee documents.

Supervisory expectations for the credit risk management approach used by individual banks should be commensurate with the scope and sophistication of the bank's activities.

For smaller or less sophisticated banks, supervisors need to determine that the credit risk management approach used is sufficient for their activities and that they have instilled sufficient risk-return discipline in their credit risk management processes.

The changes in the Standardised Approach for credit risk seek to strengthen the existing regulatory capital standard in several ways. These include:

 - Reduced reliance on external credit ratings

 - Enhanced granularity and risk sensitivity

 - Updated risk weight calibrations, which for purposes of this consultation are indicative risk weights and will be further informed by the results of a quantitative impact study

 - More comparability with the internal ratings-based (IRB) approach with respect to the definition and treatment of similar exposures

 - Better clarity on the application of the standards.

Enhancing risk coverage after Basel III

One of the key lessons of the crisis has been the need to strengthen the risk coverage of the capital framework. Failure to capture major on- and off-balance sheet risks, as well as derivative related exposures, was a key destabilising factor during the crisis.

 In response to these shortcomings, the Basel Committee in July 2009 completed a number of critical reforms to the Basel II framework. These reforms will raise capital requirements for the trading book and complex securitisation exposures, a major source of losses for many internationally active banks.

The enhanced treatment introduces a stressed value-at-risk (VaR) capital requirement based on a continuous 12-month period of significant financial stress.

In addition, the Committee has introduced higher capital requirements for so-called resecuritisations in both the banking and the trading book.

The reforms also raise the standards of the Pillar 2 supervisory review process and strengthen Pillar 3 disclosures.

 The Basel Committee also introduces measures to strengthen the capital requirements for counterparty credit exposures arising from banks’ derivatives, repo and securities financing activities.

These reforms will raise the capital buffers backing these exposures, reduce procyclicality and provide additional incentives to move OTC derivative contracts to central counterparties, thus helping reduce systemic risk across the financial system.

They also provide incentives to strengthen the risk management of counterparty credit exposures.

To this end, the Basel Committee is introducing the following reforms:

(a) Going forward, banks must determine their capital requirement for counterparty credit risk using stressed inputs.

This will address concerns about capital charges becoming too low during periods of compressed market volatility and help address procyclicality.

The approach, which is similar to what has been introduced for market risk, will also promote more integrated management of market and counterparty credit risk.

(b) Banks will be subject to a capital charge for potential mark-to-market losses (ie credit valuation adjustment – CVA – risk) associated with a deterioration in the credit worthiness of a counterparty.

While the Basel II standard covers the risk of a counterparty default, it does not address such CVA risk, which during the financial crisis was a greater source of losses than those arising from outright defaults.

(c) The Committee is strengthening standards for collateral management and initial margining. Banks with large and illiquid derivative exposures to a counterparty will have to apply longer margining periods as a basis for determining the regulatory
capital requirement. Additional standards have been adopted to strengthen collateral risk management practices.

(d) To address the systemic risk arising from the interconnectedness of banks and other financial institutions through the derivatives markets, the Committee is supporting the efforts of the Committee on Payments and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) to establish strong standards for financial market infrastructures, including central counterparties.

 A bank’s collateral and mark-to-market exposures to CCPs meeting enhanced principles will be subject to a low risk weight, proposed at 2%; and default fund exposures to CCPs will be subject to risk-sensitive capital requirements.

These criteria, together with strengthened capital requirements for bilateral OTC derivative exposures, will create strong incentives for banks to move exposures to such CCPs.

Moreover, to address systemic risk within the financial sector, the Committee also is raising the risk weights on exposures to
financial institutions relative to the non-financial corporate sector, as financial exposures are more highly correlated than non-financial ones.

(e) The Basel Committee is raising counterparty credit risk management standards in a number of areas, including for the treatment of so-called wrong-way risk, ie cases where the exposure increases when the credit quality of the counterparty deteriorates.

It also issued final additional guidance for the sound backtesting of counterparty credit exposures.

 The Basel Committee has assessed a number of measures to mitigate the reliance on external ratings of the Basel II framework. The measures include requirements for banks to perform their own internal assessments of externally rated securitisation exposures, the elimination of certain “cliff effects” associated with credit risk mitigation practices, and the incorporation of key elements of the IOSCO Code of Conduct Fundamentals for Credit Rating Agencies into the Committee’s eligibility criteria for the use of external ratings in the capital framework.

The Basel Committee also is conducting a more fundamental review of the securitisation framework, including its reliance on external ratings.

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