Will Basel III Kill Credit Models?

 

Basel III, with its requirement that banks risk-weight their assets to calculate their capital levels, will bring about sweeping changes in the way banks assess the credits on their books. Banks may need to rely less on the types of stochastic models they’ve used in the past, which plot hundreds of possible scenarios to determine a reasonable probability of default.

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About sahriskmanager

I have worked as a Head of Risk and a risk culture builder at both Asset Management and Commercial Banking Institutions within and outside of Pakistan. Over the years I have developed exhaustive understanding of risks that exist in both Sharia and Conventional Finance related Investments and Financing/Lending Products. I have invaluable experiences to share with respect to setting up and restructuring of Financial Risk Management Departments at Islamic Banks and Asset Management Firms . This includes developing policy and procedure manuals, recruiting of staff, imparting Risk Trainings and preparing the entire SDI (System, Design & Installation) work-flow frameworks for the department itself. What I shall post on these blog pages are my personal experiences, global risk management issues and academic interests which I would like to share with academicians, students and practitioners of FRM - Financial Risk Management all over the world.
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2 Responses to Will Basel III Kill Credit Models?

  1. Samchappelle says:

    Interesting. I’m not familiar with Basel at all, so correct me if I’m wrong – does this mean that risk will directly decrease the value of an asset under these new requirements (in the form of a weighted average where more risk decreases the PV of an asset), as opposed to methods previously used by banks, such as simulation based on a stochastic model (like a Monte Carlo, for example) to come up with an expected value for their assets?

    • that remains to be seen! #
      The RWA – Risk Weighted Assets under Basel II were calculated using PIT – Point in Time PDs. Hence the the capital charges suffered because of pro-cyclical nature of certain economic capital model driven hair cuts. This implies that when the economy is booming , a bank would keep lower amounts of risk capital and the opposite holds true under recessionary stages.
      Well…remains to be seen as to how the New TTCPD – Through the Cycle Probability of Default Models will improve banks risk capital buffer and put them in a better position to hedge against unforeseen risks.
      But again the law averages is my single biggest worry! for e.g. as we see in the case of portfolio diversification, the number of stocks added to a portfolio reduces the latter’s overall correlation metric(assuming higher diversification would lead to inverse correlation movements between stock returns) . Try to compare this scenario with the PDs – probability of defaults for a portfolio.
      A TTCPD Model/s would tend to average out the good and bad PDs and hence may produce a lower number due to inverse correlations and the averaging out effects.
      What yous take on that? 😉
      For further reading and analysis of credit risk models, kindly go through Merton Structural PD Model (earlier bought by the KMV Corporation and I think now acquired by the Moody’s Corporation) and BASEL II / IRB PILLAR 1 ASRF – Asymptotic Single Risk Factor Model specifications.

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