The development of commercial banking in Czechoslovakia and the Czech Republic in the course of market reform since 1990 has coincided with a wave of financial deregulation worldwide, as well as the globalization of banking business. Potentially, the emerging Czech banking sector could have benefited a great deal from this innovative process by tuning its own development to new international standards and expertise. In practice, however, it has taken the whole decade in the Czech Republic for this industry to overcome the infant diseases of mismanagement, connected lending practices and other typical emerging market shortcomings. At the end of this trail-and-error learning process, the Czech commercial banking market is now almost entirely occupied by entities under the control of parent companies from EU countries, as well as branches and subsidiaries of internationally active foreign banks.
This situation creates two types of challenges for the Czech National Bank. On the one hand, as the banking sector regulator, it will be henceforth confronted with risk management practices coming from banks with a long history, experience and an established record. So far, it has had only limited opportunities for acquiring reliable knowledge of specific consequences that the implementation of these practices might have for bank clients used to different treatment. Particularly, valuation of loans to corporate and private borrowers in the Czech economy might lead to different credit allocation decisions, economic and regulatory capital requirements, compared to established industrial economies. On the other hand, the transmission of monetary policy decisions to the investment, production and consumption behavior of the private sector in the course of adapting to different financing mechanisms may create unexpected effects in the observed price setting and real economic activity. This is why the central bank needs to improve its understanding of how bank balance sheet risks, particularly credit risk, can be measured, managed and regulated in the operation of financial institutions that are its prime partners in the domestic financial market. Specifically, the monetary and regulatory authorities must have an up to date, quantifiable picture of both the trends in regulatory treatment of capital requirements for credit risk (developed and disseminated by the BIS), as well as internal procedures and models it is likely to observe in the credit risk management of domestically licensed banks themselves.
The present paper is a step in the direction of systemizing and partially quantifying the economic and regulatory capital procedures related to credit risk that are likely to be relevant for policy making by the Czech National Bank. Particular attention is paid to the methodological problems that can arise when one attempts to implement a specific rule or model in the Czech Republic. The nature of these problems can be both institutional (non existence, shallowness, and intransparency of capital market segments or pricing distortions in these relevant segments) and technical (lack of necessary data due to inadequate accounting and reporting practices).
The Basle Committee recently released The New Basle Capital Accord,“ a document that reassesses the challenges faced lately by banking supervision and regulation. Its inception was aimed at providing a more refined methodology for computing regulatory capital in large, internationally oriented banks and at bringing the old guidelines of the 1988 Capital Accord in line with the latest developments undertaken by banks and financial markets all over the world. At least three points of criticism of the original 1988 Basle Capital Accord constitute the basis for this revision. First, the methodology for determining the regulatory capital has usually been perceived as too mechanical. Also, it seems that the risk buckets employed by it have made only an approximate distinction among risks faced by different lending sectors. Second, risks inherent in the banking sector, such as market or concentration risks, have only played a partial role in the old guidelines. Third, banks‘ increased use of off balance sheet transactions and regulatory capital arbitrage practices such as securization have rendered the old standards for assessing the capital adequacy of banks insufficient in certain cases.
The main advancement proposed by the New Basle Capital Accord is a shift from rules-based to process-oriented regulatory practices and methods (Karacadag and Taylor, 2000). In practice, this means a transfer of emphasis from the strict categories and formulas employed so far to a more refined and flexible approach. Banks will be allowed for example to use credit ratings developed by external agencies in order to assess the quality of their individual obligors. Thus, if under the old guidelines, claims on industrial and commercial enterprises were assigned a 100% risk weight, under the new approach, they could receive a smaller weight, provided they belonged to a risk free country and were assigned a high rating by an external agency. In the foreseeable future, banks will also be allowed to develop internal rating systems and, eventually, to use industry-sponsored models for determining the amount of regulatory capital they must hold.
One potential implication of the change in emphasis from rules-based to process oriented regulatory practices is that the difference between regulatory and economic capital could diminish over time. Economic capital represents an estimation by the bank‘s managers of the capital that must be held in order to cover bank‘s unexpected credit losses. Regulatory capital is a capital measure considered as adequate by regulators to maintain the soundness and stability of the banking system as a whole. In principle, the regulatory capital exceeds the economic capital that banks would like to maintain, unless banks are conservative and risk averse. The margin that makes the difference accounts for the negative externalities that an individual bank failure would impose on the banking system. Potential convergence of regulatory capital to economic capital is thus based on the implicit assumption that the estimations of the internal credit risk models are reliable enough to also account for overall system stability.
During the last decade, effort was directed towards developing models that accurately capture the risk associated with banks‘ lending activities and make reliable predictions of the economic capital banks have to maintain. Roughly in the second part of the last decade, well known financial institutions released their credit risk models to the public: JP Morgan‘s Credit Metrics/Credit Manager, Credit Risk of Crédit Suisse Financial Products, the KMV model of the KMV Corporation and, finally, McKinsey‘s Credit Portfolio View. Even if, in principle, all these models attempt to capture the risk associated with obligors‘ defaults and, eventually, migrations to a lower credit quality, assessed within a Value at Risk framework, their modeling approaches exhibit a high range of diversity. Credit Metrics and KMV follow a dynamic asset pricing approach and are based on a Merton-type model of the firm‘s value.
In this paper, a review of both the internal and regulatory approaches is undertaken. The description of each model is given in the same structure. We name the underlying assumptions of the given model both from the standpoint of the bank and the environment in which it operates, discuss the underlying theoretical approach and give a summary of its main advantages and limitations. Also, whenever possible, comparisons of the models will explore their common and distinct features in order to assess their relative advantages and limitations. Last but not least, attention will be paid to the potential impact that the use of these models could have on credit allocation in the Czech Republic and to possible recommendations for their implementation in this country. Credit Risk draws intensively on the actuarial models used in insurance economics. Finally, Credit Portfolio View introduces an econometric approach that links macroeconomic variables to the credit quality of individual obligors.
Contents
1. Introduction
2. Literature review
3. The regulatory and internal model-based approaches to credit risk
- 3.1 The BIS approach (regulatory capital)
3.2 Risk weights for corporate exposures
3.3 Inputs to the risk-weighting functions
3.4 The Value at Risk framework for credit risk (economic capital)
4 Internal credit risk models
4.1 CreditMetrics
- 4.1.1 Definitions and assumptions
4.1.2 An individual asset value distribution at the end of the risk horizon and the default probability of an obligor
4.1.3 Porfolio loss distribution
4.1.4 The Monte Carlo simulation
4.1.5 Advantages and limitations
4.2 The KMV model
- 4.2.1 Definitions and assumptions
4.2.2 Risk calculationas a the asset level
4.2.3 Advantages and limitations
4.3 Credit Risk
- 4.3.1 Definitions and assumptions
4.3.2 Risk calculations at the asset and portfolio level
4.3.3 Advantages and limitations
4.4 Credit Portfolio View
- 4.4.1 Definitions and assumptions
4.4.2 Default (migration) probabilities conditional on the state of the economy
4.4.3 Advantages and limitations
5 Comparison of individual methods
5.1 Formal differences in individual methods
5.2 Advantages and limitations of individual methods
- 5.2.1 Advantages
5.2.2 Limitations
6 The potential impact on banks and on credit allocation in the Czech Republic
- 6.1 Current state and perspectives
6.2 Recommendations for the Czech Republic
7 Conclusion
Literature
Appendix
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