Compliance with Basel II has the potential to bring improved financial performance to an organisation but only if it is applied uniformly across the whole organisation, says Jason Kofman.
Each bank’s Basel II strategy must include a thorough analysis of the costs and benefits. Banks have much to gain from investments in Basel II Internal Ratings Based (IRB) compliance so long as those investments are adopted with an understanding of the economic trade-offs between risk and return, are distributed consistently throughout the organisation, are imbedded in day-to-day business practices, and are adopted with an understanding of the economics of credit portfolio management.
These investments enable banks to realise more consistent profits and reduced volatility of credit losses by taking a structured and consistent view of risk management. Also, banks may actually realise an increase in profits in the form of lower provisions, consistent risk spreading, more effective deployment of capital and loss avoidance.
Senior bank managers have legitimate concerns about the IRB approaches, due to the potentially large price tag. However, many banks view IRB compliance as an investment. And like all investments, it is imperative to measure its expected return.
The benefits of IRB compliance can be grouped into two parallel categories:
- Making better decisions: differentiating risk on an asset-by-asset level adds transparency to the credit decision-making process and empowers better economic decision making.
- Making decisions consistently: many banks that grew by acquisition have neither consolidated nor harmonised their internal risk systems. This has led to inconsistent and incomplete credit processes, creating gaps and inconsistencies in risk measurement. Applying risk rating models consistently across the organisation improves the quality of risk reporting and decision-making.
It is important to recognise that the quality and consistency of risk decision-making are not independent, rather are mutually reinforcing. Both are required to reap the full benefits from the investment.
Making better decisions
IRB compliance supports better decision-making from the loan level up to the portfolio and business unit level. While IRB compliance is defined only at the individual loan level, outputs from these IRB calculations drive key decisions at the portfolio and business unit levels.
At the loan level, this includes differentiating between similar looking borrowers through more effective risk-rating models and separating out the risk of recovery in the event of default from a borrower’s creditworthiness. These changes improve the granularity of risk levels assigned by the bank, which aids in more differentiated provisioning and, more importantly, adds visibility into pricing decisions.
Attaining this loan-level, risk-management insight provides the key elements to understanding the returns and risk necessary to differentiate among existing clients or compete for new business. Once this foundation is laid, a bank can make incremental investments to reap further rewards from risk-based decision-making at the next level – the portfolio, through measurement of economic capital and risk-adjusted performance.
Making consistent decisions
Data management is the highest hurdle for most banks seeking IRB compliance. Better decisions are only possible with useful data driving the analyses. Banks need to collect and store financial and non-financial risk drivers for each customer. This not only forms the basis for internal rating models but is also the core of the bank’s model development and validation dataset. Therefore, it must be collected for each customer in a consistent fashion and stored in a comprehensive and secure way.
Technologically, many banks need systems that enforce network-wide solutions. The technology platform must be able to reach each end user – and in many banks that means a branch network with varying degrees of IT infrastructure. Finally, the technology footprint should be able to accommodate expected growth by the bank, both organic and by acquisition.
Basel II represents a significant opportunity for banks to enhance their risk management processes, models, abilities and links with the rest of the organisation. These improvements do not come without their cost in terms of time, resources and organisational fatigue. However, using industry-standard software and models reduces these. It is incumbent upon bank managers to make well-informed decisions regarding Basel II compliance in light of its potential benefits and costs. Those banks that make the investment in their risk management capabilities for economic decision-making, as well as those pursuant to IRB, will have a significant advantage relative to those who seek mere compliance.
Jason Kofman works with clients in Europe, Middle east and Africa for Moody’s KMV. E-mail: Jason.kofman@mkmv.com
