02/05/2012
You may be interested in this write-up by our colleague Ramzi Watfa on the impact of Basel Accords and its implications. This is taken from his new book on "Introduction to Corporate and Commercial Credit".
Basel’s findings
Prior to its publication of the June 2004 accords , the Basel Committee identified several traits relating to how banks generally operated up until then. Some of the more serious findings included the following:
1. Inadequate Risk Assessment
a) Approving credits based on simple indicators.
b) Lack of testing and validation.
c) Subjective decision making by senior management.
d) Lack of risk-sensitive pricing.
2. Lack of Use of Analytical Techniques
a) Lack of accounting of business cycle effects.
b) Lack of consideration of a downside scenario.
c) Lack of forward looking methodology.
d) Lack of use of cash flows.
3. Lax Credit Process
a) Lack of an effective credit review process.
b) Failure to monitor borrower or collateral values.
The Basel 2 Accords came into being to adjust all of this. The unfortunate part it was 21 years after some of the more renowned international banks were already well underway in terms of adopting very similar principals. Even at this late stage, many banks have not yet corrected their paths; relying on antiquated methodologies and policies.
Our findings: A vast difference between Basel 1 and Basel 2 environments.
The world of Basel 1 treated all obligors the same. It was a “process-based” world, where credit processes were more important than the applications; where the 5 “C”s where applied on all clients irrespective; where the officers were fidgeting in the balance sheet and income statement for clues and comparisons between companies while the real story was in the cash flows. This narrow view left many banks unable (intentionally or otherwise) to measure risks; and as increased assets and profitability continued to play important roles in the psyche of bankers, the true value of the portfolio was largely ignored. It was not whether the obligor could pay back or not, it was what collateral security was available to cover the financing. The issue of how much the obligor needed was focused almost purely on individual transactions and was not aligned to the obligor’s business characteristics and overall needs.
This tunnel vision has lead, and indeed continues to lead to an overstatement of the quality of many a bank’s portfolio. Coupled with lack of sound principals in banking along with the discipline to implement them, the world of finance continues to be dominated by large losses and misappropriation of shareholder value.
Basel 2 environment has gone a long way to address the above shortcomings in the management of banking business. It finally recognized the need to improvement the measurement of risk, and has encouraged banks to adopt it through economic measures such as more efficient capital adequacy allocations. What a bank did not need in extra capital to cover a measured credit risk position could now be used to cover market or operational risks.
However following over 6 years of the introduction of these accords, it is surprising that banks did not change much quicker, and have yet to adopt any of the new principals. I believe the reason for this slow pace is two-fold: (a) the Central Banks which are normally the instruments of change are themselves in need of a total overhaul; they need to learn what it takes to manage banks and measure risk much more rigorously than the banks themselves, and (b) that Basel 2 left it to the shareholders to decide whether to have their banks remain in the world of Basel 1 - The Standardized Approach, or move forward into the IRB Approaches. Had Basel 2 enforced a deadline for IRB methodologies then we would have probably witnessed more professionalism across the banking sector in almost all countries.
So what’s this book all about
This book is intended to help banks identify what changes are needed to be able to master credit for corporate and commercial obligors, and to recognize that the ensuing changes are not necessarily onerous in terms of financial outlay. The banks that are still in the realms of Basel 1 or Standardized Mode need to change fast. Those that have started with the changes have to check (a) whether they have adopted all the necessary steps for change (change is not about buying a new risk rating system), and (b) whether the steps that have been adopted were adequate enough.
This book is also intended to introduce a methodology that makes credit analysis easier, more focused, more accurate, and streamlined in terms of making a decision. The methodology helps determine the quality of obligors, the exposure that is appropriate to them in line with their risks, and the level of pricing that should be imposed to balance this risk. The methodology also ties in seamlessly with portfolio management, early problem recognition and the optimization of capital adequacy. This methodology begins with the most sacred of all criteria in credit risk, the ability of obligors to meet their obligations, and it is therefore cash flow centric with a twist.
A lot has been written on calculating default, and indeed much will continue to be so. Very little has been written on what banks should do to change and how to implement this change. If a bank were to start with the simple identification of what creates default, all other processes will follow suit neatly. The various methodologies to calculate capital adequacy are based on this simple notion. In addition Basel’s guidelines on Credit Risk are very good top-level rules to be followed. I hope this book will compliment them by introducing practical steps to adopting them in full.
