The Basel Committee proposals for a new capital accord: implications for Italian banks

Following a few general considerations on the recently proposed revision of the Basel Agreement on capital adequacy, this paper focuses on the first pillar of the Basel Committee proposals, the handling of capital requirements for credit risk in the banking book. The Basel Committee envisages an approach alternatively based on external ratings or on internal rating systems for the determination of the minimum capital requirement related to bank loan portfolios. This approach supports a system of capital requirements that is more sensitive to credit risk. On the basis of specific assumptions, these requirements provide a measure of the value at risk (VaR) produced by models used by major international banks. We first address the impact of the standardised and (internal ratings-based) IRB foundation approach using general data on Italian banks loans' portfolios default rates. We then simulate the impact of the proposed new rules on the corporate loan portfolios of Italian banks, using the unique data set of mortality rates recently published by the Bank of Italy. Three main conclusions emerge from the analysis: (i) the standardised approach implicitly penalizes Italian banks in their interbank funding as their rating is generally below AA/Aa, (ii) the average default rate experienced by Italian banks is higher than the one implied in the benchmark risk weight (BRW) proposed by the Basel Committee for the IRB foundation approach, thereby potentially leading to an increase in the regulatory risk weights, and (iii) the risk-weight is based on an average asset correlation that is significantly higher than the one historically recorded within the Italian banks' corporate borrowers. These findings support the need for a significant revision of the basic inputs and assumptions of the Basel proposals. Finally, in relation to the conditions that allow the capital market to effectively discipline banks, we comment on the proposals advanced in relation to the third pillar of the new capital adequacy scheme.     

A Tractable Model to Measure Sector Concentration Risk in Credit Portfolios

We explore a simplified version of the value-at-risk approximation developed by Pykhtin (Risk Magazine, March, 85–90, 2004), which only requires risk parameters on a sector level. We measure the impact of credit concentrations in business sectors on the economic capital of credit portfolios. We base our portfolios’ sector composition on credit information from the German central credit register. Our results show that the approximation formula performs well for fine-grained portfolios that are homogeneous on a sector level in terms of probability of default (PD) and exposure size. We explore the robustness of our results for portfolios which are heterogeneous in terms of these two characteristics. We find that low granularity ceteris paribus causes the approximation formula to underestimate economic capital, whereas heterogeneity in individual PDs causes overestimation. Indicative results imply that in typical credit portfolios of banks, PD heterogeneity will at least compensate for the granularity effect. This result suggests that the approximation estimates economic capital reasonably well and/or errs on the conservative side.     

Measuring Integrated Market and Credit Risk in Bank Portfolios: An Application to a Set of Hypothetical Banks Operating in South Africa

The banking crises of the ‘90s emphasize the need to model the connections between financial environment volatility and the potential losses faced by financial institutions resulting from correlated market and credit risks. Due to the number of variables that must be modeled and the complexity of the relationships an analytical solution is not feasible. We present here a numerical solution based on a simulation model that explicitly links changes in the relevant variables that characterize the financial environment and the distribution of possible future bank capital ratios. This forward looking quantitative risk assessment methodology allows banks and regulators to identify potential risks before they materialize and make appropriate adjustments to bank portfolio credit qualities, sector and region concentrations, and capital ratios on a bank by bank basis. It also has the potential to be extended so as to assess the risks of correlated failures among a group of financial institutions (i.e., systemic risk analyses). This model was applied by the authors to the study of the risk profile of the largest South African Banks in the context of the Financial System Stability Assessment program undertaken by the IMF in 1999. In the current study, we apply the model to various hypothetical banks operating in the South African financial environment and assess the correlated market and credit risks associated with business lending, mortgage lending, asset and liability maturity matches, foreign lending and borrowing, and direct equity, real estate, and gold investments. It is shown to produce simulated financial environments (interest rates, exchange rates, equity indices, real estate price indices, commodity prices, and economic indicators) that match closely the assumed parameters, and generate reasonable credit transition probabilities and security prices. As expected, the credit quality and diversification characteristics of the loan portfolio, asset and liability maturity mismatches, and financial environment volatility, are shown to interact to determine bank risk levels. We find that the credit quality of a bank's loan portfolio is the most important risk factor. We also show the risk reduction benefits of diversifying the loan portfolio across various sectors and regions of the economy and the importance of accounting for volatility shocks that occur periodically in emerging economies. Banks with high credit risk and concentrated portfolios are shown to have a high risk of failure during periods of financial stress. Alternatively, banks with lower credit risk and broadly diversified loan portfolios across business and mortgage lending are unlikely to fail even during very volatile periods. Asset and liability maturity mismatches generally increase bank risk levels. However, because credit losses are positively correlated with interest rate increases, banks with high credit risk may reduce overall risk levels by holding liabilities with longer maturities than their assets. Risk assessment methodologies which measure market and credit risk separately do not capture these various interactions and thus misestimate overall risk levels.     

Competitive effects of Basel II on US bank credit card lending

We analyze the potential competitive effects of the proposed Basel II capital regulations on US bank credit card lending. We find that bank issuers operating under Basel II will face higher regulatory capital minimums than Basel I banks, with differences due to the way the two regulations treat reserves and gain-on-sale of securitized assets. During periods of normal economic conditions, this is not likely to have a competitive effect; however, during periods of substantial stress in credit card portfolios, Basel II banks could face a significant competitive disadvantage relative to Basel I banks and nonbank issuers.     

A macro stress test model of credit risk for the Brazilian banking sector

This paper proposes a model to conduct macro stress test of credit risk for the banking sector based on scenario analysis. We employ an original bank-level data set that splits bank credit portfolios in 21 granular categories, covering household and corporate loans. The results corroborate the presence of a strong procyclical behavior of credit quality, and show a robust negative relationship between the logistic transformation of non-performing loans (NPLs) and GDP growth, with a lag response of up to three quarters. The results also indicate that the procyclical behavior of loan quality varies across credit types. This is novel in the literature and suggests that banks with larger exposures to highly procyclical credit types and economic sectors would tend to undergo sharper deterioration in the quality of their credit portfolios during an economic downturn. Lack of sufficient portfolio granularity in macro stress testing fails to capture these effects and thus introduces a source of bias that tends to underestimate the tail losses stemming from the riskier banks in a system.     

M‐PRESS‐CreditRisk: Microprudential and Macroprudential Capital Requirements for Credit Risk under Systemic Stress

M‐PRESS‐CreditRisk is a novel stress testing approach that can help authorities gauge banks' capital adequacy related to credit risk. For the first time, it combines the assessment of microprudential capital requirements under Pillars 1 and 2 and macroprudential buffers in a unified, coherent framework. Its core element is an advanced credit portfolio model—SystemicCreditRisk—built upon a rich, nonlinear dependence structure for correlated bank portfolios. The model is applied to a sample of 12 systemically important German banking groups and delivers measures for systemic credit risk and the banks' contributions to it in both baseline and stress scenarios.     

An Assessment of Basel II Procyclicality in Mortgage Portfolios

In this paper we develop a probability of default (PD) model for mortgage loans, taking advantage of the Spanish Credit Register, a comprehensive database on loan characteristics and credit quality. From that model, we calculate different types of PDs: point in time, PIT, through the cycle, TTC, average across the cycle and acyclical. Then, we compare capital requirements coming from the different Basel II approaches. We show that minimum regulatory capital under Basel II can be very sensitive to the risk measurement methodology employed. Thus, the procyclicality of regulatory capital requirements under Basel II is an open question, depending on the way internal rating systems are implemented and their output is utilised. We focus on the mortgage portfolio since it is one of the most under researched areas regarding the impact of Basel II and because it is one of the most important of banks’ portfolios.     

The credit quality channel: Modeling contagion in the interbank market

We propose an algorithm to model contagion in the interbank market via what we term the “credit quality channel”. In existing models on contagion via interbank credit, external shocks to banks often spread to other banks only in case of a default. In contrast, shocks are transmitted also via asset devaluations and deteriorations in the credit quality in our algorithm. First, the probability of default (PD) of those banks directly affected by some shock increases. This increases the expected loss of the credit portfolios of the initially affected banks’ counterparties, thereby reducing the counterparties’ regulatory capital ratio. From a logistic regression we estimate the increase in the counterparties’ PD due to a reduced capital ratio. Their increased PDs in turn affect the counterparties’ counterparties, and so on. This coherent and flexible framework is applied to the bilateral interbank credit exposure of the entire German banking system in order to examine policy questions. For that purpose, we propose to measure the potential cost of contagion of a given shock scenario by the aggregated regulatory capital loss computed in our algorithm.     

Ratings-based credit risk modelling: An empirical analysis

Banks have recently developed new techniques for gauging the credit risk associated with portfolios of illiquid and defaultable instruments. These techniques could revolutionise banks' management of credit risk and could in the longer term serve as a more risk-sensitive basis for calculating regulatory capital on banks' loan books than in Basel 2, the new regulatory capital framework. In this paper we implement a popular credit risk model that exploits the information in credit ratings to determine a portfolio's value-at-risk. Using price data on large eurobond portfolios, we assess, on an out-of-sample basis, how well the model tracks the risks it is supposed to measure.     

Securitization and Bank Performance

Using predominantly precrisis U.S. commercial bank data, this paper employs a propensity score matching approach to analyze whether individual banks did improve their performance through securitization. On average, our results show that securitizing banks tend to be more profitable institutions, with higher credit risk exposure. Despite a more diversified funding structure, they face higher funding costs. We also find that securitizing banks tend to hold larger and less diversified loan portfolios, have less liquidity, and hold less capital. However, our analysis does not provide evidence to suggest that securitization had an impact upon bank performance.     

Optimal credit risk transfer, monitored finance, and banks

We examine the implications of optimal credit risk transfer (CRT) for bank-loan monitoring, and the incentives for banks to engage in optimal CRT. In our model, properly designed CRT instruments allow banks to insure themselves against loan losses precisely in those states that signal monitoring. We find that optimal CRT enhances loan monitoring and expands financial intermediation, in contrast to the findings of the previous literature. Optimal CRT instruments are based on loan portfolios rather than individual loans and have credit-enhancement guarantees, pretty much as banks do in practice. But the extent of credit enhancement needs to be precisely delimited. Above that exact level, monitoring incentives are undermined (loan quality deteriorates) and wealth is transferred from the bank's financiers to the bank. Properly designed risk-based capital requirements are shown to prevent such a wealth transfer and to provide banks with the incentive to engage in optimal CRT.     

预期信用损失模型对银行资本计提的结构性影响研究——基于50家上市商业银行的实证分析

预期信用损失模型是一项新的贷款损失准备计提方法,对其经济后果的评估非常重要.关于预期信用损失模型的实施对我国商业银行资本计提的具体影响,目前还缺乏深入系统的研究.本文结合我国50家上市商业银行的公开数据,从监管资本、会计损益和资本计提前瞻性的角度分析了预期信用损失模型对我国商业银行资本计提的影响.研究结果表明:总体影响上,商业银行的贷款损失准备计提金额显著增加,利润波动增强,对资本充足率带来一定冲击;从不同特征商业银行看,小型商业银行、使用权重法商业银行、城市商业银行和H股上市商业银行受到的影响更为严重;从资本计提的前瞻性看,贷款损失准备的前瞻性得到加强,顺周期性效应得到一定程度缓解,但并不能完全消除.     

The impact of FDICIA and prompt corrective action on bank capital and risk: Estimates using a simultaneous equations model

One of the requirements of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) was that bank regulators establish capital ratio zones that mandate prompt corrective action (PCA) and early intervention in troubled banks. However, prior research suggests that increases in regulatory capital standards can lead to offsetting increases in risk. This paper develops and estimates a 3SLS model to examine the simultaneous impact of PCA on both bank capital and credit risk. The results document that the FDICIA was effective in that, subsequent to its passage, US banks increased their capital ratios without offsetting increases in credit risk.     

Earnings versus capital ratios management: role of bank types and SFAS 114

We document in this paper that large banks use Loan Loss Provisions (LLP) more than small banks to manage reported earnings, but we find no significant difference in the use of LLP to manage capital ratios between large and small banks. Additionally, we document that banks with high risk asset portfolios use more LLP to manage reported earnings as well as capital ratios compared to the banks with low risk asset portfolios. Our findings also show that SFAS 114 has a moderating effect on the use of LLP to manage reported earnings, especially by large banks, but there is no conclusive evidence on the impact of SFAS 114 to manage capital ratios. Furthermore, the findings show that there has been significantly more earnings management during the 2007–2008 financial crisis compared to earlier periods.     

Capital shocks, bank asset allocation, and the revised Basel Accord

In contrast to the 1988 Basel Accord (Basel I), the revised risk-based capital standards (Basel II) propose regulatory capital requirements based on credit ratings. This paper develops a theoretical model to analyze how banks will adjust their low and high credit risk commercial loans under the proposed newer standard. Capital-constrained banks respond to an adverse capital shock by reducing high credit risk loans, while under certain circumstances, low credit risk loans may actually increase. When compared to Basel I, it is shown that high-risk loans are reduced more under Basel II, but whether a bank reduces total lending more under Basel I or under the revised standards depends on a complex interaction of factors.     

Structural effects of asset-backed securitization

This paper analyses the potential changes in the operational structure of deposit-taking financial institutions that securitize assets. Findings indicate that banks can create an asset securitization pipeline structure that enables them to increase their return on capital. In other words, through securitization banks can expand their loan provision business without increasing their liabilities or their capital levels. Using a contingent claims model, four factors that impact on the bank's decision to securitize are highlighted and analysed: (i) the level of deposit insurance; (ii) capital adequacy requirements; (iii) insolvency risk; and, (iv) the risk of credit enhancements. Furthermore, we identify key accounting and regulatory challenges that emerge for banks from the process of asset backed securitization.     

The disciplining effect of supervisory scrutiny in the EU-wide stress test

Relying on confidential supervisory data related to the 2016 EU-wide stress test, this paper presents novel empirical evidence that supervisory scrutiny associated to stress testing has a disciplining effect on bank risk. We find that banks that participated in the 2016 EU-wide stress test subsequently reduced their credit risk relative to banks that were not part of this exercise. Relying on new metrics for supervisory scrutiny that measure the quantity, potential impact, and duration of interactions between banks and supervisors during the stress test, we find that the disciplining effect is stronger for banks subject to more intrusive supervisory scrutiny during the exercise. We also find that a strong risk management culture is a prerequisite for the supervisory scrutiny to be effective. Finally, we show that a similar disciplining effect is not exerted neither by higher capital charges nor by more transparency and related market discipline induced by the stress test.     

Macroprudential stress testing of credit risk: A practical approach for policy makers

Drawing on the lessons from the global financial crisis and especially from its impact on the banking systems of Eastern Europe, the paper proposes a new practical approach to macroprudential stress testing. The proposed approach incorporates: (i) macroeconomic stress scenarios generated from both a country specific statistical model and historical cross-country crises experience; (ii) indirect credit risk due to foreign currency exposures of unhedged borrowers; (iii) varying underwriting practices across banks and their asset classes based on their relative aggressiveness of lending; (iv) higher correlations between the probability of default and the loss given default during stress periods; (v) a negative effect of lending concentration and residual loan maturity on unexpected losses; and (vi) the use of an economic risk weighted capital adequacy ratio as the relevant outcome indicator to measure the resilience of banks to materializing credit risk. The authors apply the proposed approach to a set of Eastern European banks and discuss the results.     

The integrated impact of credit and interest rate risk on banks: A dynamic framework and stress testing application

Credit and interest rate risk are the two most important risks faced by commercial banks in their banking book. In this paper we derive a consistent and comprehensive framework to measure the integrated impact of both risks. By taking account of the repricing characteristics of assets, liabilities and off balance sheet items, we assess the integrated impact of credit and interest rate risk on banks’ economic value and capital adequacy. We then stress test a hypothetical but realistic bank using our framework and show that it is fundamental to measure the impact of credit and interest rate risk jointly.     

Capital requirements under the credit risk-based framework

This work aims to study the hypothesis of lower capitalization of banks under the risk-based rules introduced in Basel II. In this sense, an assessment of the impact of these rules on the capital requirements for non-financial firms’ credit risk is performed. A comparison with Basel I is presented and intervals of variation for the risk drivers such that capital requirements exceed the ones under Basel I are established. Data for a European country supports the hypothesis of a smaller capitalization of banks under the risk-based framework, as far as credit risk in concerned.