Credit risk modelling Patricia Jackson, Pamela Nickell and William Perraudin, Regulatory Policy Division, Bank of England LAST AUTUMN the Bank of England and the Financial Banks are now developing models to enable the calculation Services Authority (FSA) hosted a conference to examine of value-at-risk on portfolios of credit exposures. Like developments in credit risk modelling and their regulatory market VaR models, these take into account the correlations implications. The conference was co-organised by the between returns on different exposures. Banks are starting Federal Reserve Board of Governors, the Federal Reserve to use them to allocate economic capital and as a risk Bank of New York and the Bank of Japan, and was attended management tool. William McDonough (Chairman of the by central bankers, regulators, academics and senior Basel Committee on Banking Supervision and President of practitioners working in the field. the Federal Reserve Bank of New York) said in a keynote address to the conference that the development of credit The main goal of the conference was to look at evidence risk modelling would be the catalyst for a major rethinking on the construction and reliability of credit risk models. of the theory and practice of credit risk management over This issue has financial stability implications in terms of the next few years. Other speakers also applauded their both the reliance that firms can place on models to potential use as a risk management tool. improve their credit risk management and the reliance that regulators can place on them to calculate capital Banks have been pressing for the recognition of models in requirements for credit risk, which form the main setting capital for credit books, because of distortions prudential buffer in banks’ balance sheets. The Basel created by the current requirements. The conference Committee on Banking Supervision was actively started by considering the extent to which strains had considering whether models were sufficiently well developed in applying the current standard and then developed to be used as a regulatory tool in any revision looked at developments in credit risk modelling. The key to the credit risk treatment set out in the 1988 Basel issue on which the conference attempted to shed light was Accord. the accuracy of the models. Credit risk modelling is at an earlier stage of development than modelling of trading book The 1988 Accord established a common minimum standard VaRs and the data problems are more acute, making an for the capital requirements for internationally active banks assessment of reliability essential. The conference also in the G10, the central element of which were credit risk looked at ways in which the models could be tested and requirements. In 1996, the Accord was amended to include how they might evolve in the future. new risk-based requirements for securities and fx trading books. As part of this risk-based approach, sophisticated Strains in the current system firms were given the option of requesting recognition of The 1988 Basel Accord placed exposures in broad risk their in-house value-at-risk (VaR) models to set the capital categories to which capital weights were applied: essentially requirements for their trading books. These VaR models 0 per cent for OECD government exposures, 20 per cent for assessed likely losses taking into account the volatility and interbank, 50 per cent for residential mortgages, and 100 correlations of the returns on different assets. per cent for the remainder (including the full range of 94 Financial Stability Review: June 1999 Credit risk modelling corporate exposures). The broad bands, encompassing a full models approach. In his view it was not necessary for wide range of risks, provide incentives for banks to carry Basel to adopt a full models approach — although in out regulatory arbitrage — reducing the regulatory theory that would be preferable — but any new risk measure of their risk with little or no reduction in their bucketing system would have to bear some resemblance to economic risk. banks’ own internal rating systems. David Jones (Federal Reserve Board) showed how Michael Foot (Managing Director, Financial Services securitisation and other financial innovations had enabled Authority, UK), expressed a strong preference for banks to engage in such arbitrage. This had created the supervisory tools based on methods used by the regulated danger that reported regulatory capital ratios could mask a firms themselves. He hoped that in time it would be deterioration in a bank’s true financial condition. possible for supervisors to accommodate credit risk modelling within their own regulatory procedures. But at Claes Norgren (Director General, Financial Services present the dangers, as well as the rewards, of credit risk Authority, Sweden) discussed more generally the pressures models were much greater than those of market risk models. on the current treatment of credit risk. The Accord did not He identified issues that needed to be addressed. These acknowledge risk diversification and gave only limited included the scarcity of data, particularly covering more allowance for risk reduction through collateral, guarantees than one business cycle; the scale and sophistication of the or netting. Nor did it take account of new instruments or banks that would be able to run these models; and the techniques such as credit derivatives. need for more work to be done on operational risk and on the correlations between market, credit and operational John Mingo (Federal Reserve Board) looked at the policy risk. He announced that, when UK banks could implications of regulatory arbitrage. He suggested that it demonstrate that their credit risk modelling contributed to was tempting for regulators to respond by formally sound risk management practice, the FSA would take this forbidding the procedures used by banks to reduce their into account in setting individual risk asset capital ratios effective capital requirements. But this would be ill advised, for those banks. in part because financial innovation would enable banks to find alternative avenues. Perhaps more important, Current credit risk modelling and internal grading practice regulatory arbitrage provided a safety valve, mitigating the A survey by the FSA into the use of credit risk modelling effects of capital requirements that substantially exceeded techniques in the UK found that major banks, like their an economic assessment of risk. He set out the goals for continental counterparts, had been working to incorporate prudential regulation and supervision and looked at how within their credit risk management processes models that the Basel Accord could be brought into line with the banks’ have been published or sold by third parties. The survey, own assessment of risk. There were two proposals on the described in a paper by Vyvian Bronk and Emmanuelle table — modification of the Basel risk bucket approach or a Sebton (Financial Services Authority, UK), noted that credit Credit risk modelling Financial Stability Review: June 1999 95 ... They noted that as the rating process almost always involved the exercise of human judgement, banks needed to pay careful attention to the internal incentives that could distort rating assignment ... portfolio modelling was typically confined to certain parts large and middle market corporate lending) the Federal of the asset portfolio. Different techniques were applied to Reserve study noted significant shortcomings both in different types of business. For example, “bottom-up” model construction features and model validation approaches were generally applied to individual large procedures. These included a lack of stress testing or corporate exposures (where information on each corporate backtesting. was readily available). “Top-down” models tended to be applied to retail credit portfolios, grouping together Bill Treacy and Mark Carey (Federal Reserve Board) exposures where there was little information on individual presented the results of their survey of internal rating obligors. Models were commonly used to allocate economic systems at large US banks. They noted that as the rating capital within business units and as an input to more process almost always involved the exercise of human consistent pricing of certain credit risks. However, the use judgement, banks needed to pay careful attention to the of models to create an integrated approach to overall credit internal incentives that could distort rating assignment. risk management was rare. Also, rating criteria might be largely a matter of “credit culture” rather than formal written policy, and data might One important issue discussed in the FSA’s survey related to not have been kept in a form that allowed the analysis of the choice of modelling horizon. Longer horizons implied the relationship between assigned grades and actual loss correspondingly larger possible losses. The horizon most experience. While a few US banks were moving towards commonly chosen was one year — because data on models as the primary basis for internal ratings, most still changes in credit quality (default rates and credit rating believed that properly managed judgemental rating systems transition probabilities) were most commonly available at delivered more accurate assessments of risk. this horizon. This horizon might be suitable for some purposes, but could be too short for others. An important Jeremy Gluck (Moody’s, New York) described the rating consideration when deciding upon