The Basel Ii "Use Test" - a Retail Credit Approach: Developing and Implementing Effective Retail Credit Risk Strategies Using Basel Ii

By Stephen D. Morris

The essence of this text is the application of The Basel II Framework Use Test. I will illustrate the facets of Use Test adherence with risk management tools and strategies that complement a banks pursuit of Advanced Internal Ratings Based Approach, Basel II Framework compliance. I will simultaneously pay close attention to the specific Basel II Framework, Use Test adherence measures. This book offers the practitioner a useful prescription for ensuring that their bank covers the necessary bases when pursuing its Basel II Framework implementation. It additionally puts into proper context where banks should be concerned in their pursuit of the Use Test, with specific attention to regulator, boards and executives concerns that the bank continues to operate with sound fiscal behaviour.

The very foundation of a banks lending practices is the credit cycle. This book identifies both the traditional model and the newly minted Basel II model of the credit cycle. It also demonstrates practices that create sustainable business processes which optimize the risk-reward drivers of a retail banking environment. It focuses on the different operational areas of the bank and the role each plays within the Basel II credit cycle. Finally, it provides a foundation for which the credit practices present in Marketing, Underwriting, Account Management, Portfolio Management, Recoveries and Collections and Regulatory Capital setting can be justly applied.

Banks must make use of The Basel II Framework estimation tools, thus confirming that they are predictive, accurate and reliable in the estimation of regulatory capital as well as in the day-to-day running of the bank. In spite of the prescriptive nature of The Basel II Framework model estimates this book will illustrate how to exploit their elemental design into profitable pursuits. While one fundamental challenge relating to Basel II Framework adherence is incorporating these tools into the Credit Cycle, another focuses on enhancing and improving existing credit practices found within the banks organizational structure in light of traditional banking shareholder drivers. This book thus simplifies this directive.

• Language: English
• Publisher: AuthorHouse
• Release date: Aug 5, 2008
• ISBN: 9781467839556

Book preview

The Basel II Use Test -

A Retail Credit Approach

Developing and Implementing Effective Retail

Credit Risk Strategies Using Basel II

Stephen D. Morris

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AuthorHouse™

1663 Liberty Drive, Suite 200

Bloomington, IN 47403

www.authorhouse.com

Phone: [phone]

© 2008 Stephen D. Morris. All rights reserved.

No part of this book may be reproduced, stored in a retrieval system, or transmitted by any means without the written permission of the author.

First published by AuthorHouse 7/21/2008

ISBN: 978-1-4343-7301-4 (sc)

ISBN: 978-1-4343-7302-1 (hc)

ISBN: 978-1-4678-3955-6 (ebk0

Library of Congress Control Number: 2008904817

Printed in the United States of America

Bloomington, Indiana

Contents

Acknowledgements

Introduction

Part I:

The Basel II Framework and the Use Test

(i) The Basel II Framework

(ii) What is the Use Test

(iii) Use Test Minimum Requirements

a) Time and Consistency:

b) Model Usage: Use Test:

c) Judgemental Decisioning:

d) Data Use and Data Quality:

e) Rating completeness:

f) Rating maintenance:

g) Overrides:

Part II:

The Credit Cycle

(i) The Traditional Credit Cycle

(ii) The Basel II Credit Cycle

(iii) Key Departmental Responsibilities

a) Board of Directors

b) Executive Suite & Senior Management

c) Risk Management

d) Marketing

e) Information Technology

f) Lending and Treasury

g) Finance

h) Legal

i) Audit,

Part III:

The Use Test Tools

(i) Pillar 1 – Minimum Capital Requirements

a) Data

b) The PD Model

c) The EAD Model

d) The LGD Model

e) Expected and Unexpected Loss

f) Correlation Coefficient

g) Capital Requirement

h) Risk Weighted Assets

i) Regulatory and Economic Capital

j) Model Validation

k) Model Stress-Testing

l) Reporting

m) Organizational Governance

(ii) Pillar 2 – Supervisory Review

Supervisory Review

Other Pillar 2 Considerations:

(iii) Pillar 3 – Market Discipline

a) Disclosure Requirements

b) Guiding principles

c) Achieving Disclosure

d) Accounting Disclosures

e) Materiality

f) Frequency

g) Proprietary and Confidential Information

Part IV:

Applying the Use Test in the Credit Cycle

(i) Integrated Basel II Framework Vision

Internal Benefits

External Benefits

(ii) Getting Started

Proxying PD, EAD and LGD Amounts

(iii) Marketing

a) Pre-screening

b) Reduced APR

c) Residential Mortgage Pre-approval

(iv) Underwriting

a) Borrower Qualification

b) Downpayment Requirements

c) Auto-approval

d) Risk Based or Discretionary Pricing

e) Residential Mortgage Appraisal/Valuation Policy

f) Quality Control Reviews

A Note on Limits and Authorized Amounts

(v) Account Management

a) Up-sell and Cross-sell Opportunities

b) Limit Increase and Limit Decrease

c) Account Over-limit Spending

d) Early Residential Mortgage Renewal

e) Skip-a-payment

(vi) Portfolio Management

a) Portfolio Level Reporting

b) Portfolio Expected Loss & A-IRB Capital, using IFRS – IAS-39 Methodology

c) Portfolio Level Yield, Profitability and Regulatory Capital Optimization

A Note on Capital Hurdle Rates

(vii) Recoveries

a) High, Medium & Low Priority Unsecured Loans Recovery Strategies

b) Secured Loans Collection Strategies

c) In-house vs. External Collections Strategies

(viii) Use Test Scorecard

a) Marketing Objectives

b) Underwriting Objectives

c) Account Management Objectives

d) Portfolio Management Objectives

e) Recovery Objectives

Part V:

What Comes Next

(i) Where does the Use Test and your bank go from here?

Appendix A:

Basel Committee Newsletter No. 9 (September 2006)

Basel II Framework paragraph 444

Introduction

Background of the Use Test

Use of IRB Components

Principles

Bibliography

Acknowledgements

Writing a book about something you have a passion for is truly a labour of love. However no effort of this magnitude can take place without paying grateful appreciation to the large number of people who have taught me this subject matter during the past seventeen years of my life.

I wish to thank Equifax Canada Inc. and Trans Union of Canada Inc., the two Canadian consumer credit agencies for giving me a start in this field and exposing me to this realm of work. Combined, their relentless pursuits of data completeness and superior risk assessment tools for the credit granting industry in Canada have been fine examples of blending the art and science of credit risk assessment in this business domain.

Special thanks must also be extended to several banking institutions that allowed me to learn retail banking firsthand. CIBC, Canada Trust (now TD Canada Trust), ING Direct Canada and Bank of Montreal are fine financial service stalwarts, with many fine people employed by them particularly for me in the areas of retail lending and retail credit risk. I have no doubt that the soundness of governance, corporate policy, and retail banking practices and processes within these institutions will ensure that Canadian banks continue to flourish.

However important these organizations were in teaching me this line of work, I nevertheless give my greatest thanks to my wife Cindy and children Abigail, Leora and Zachary. They have continued to stand by me in my pursuits and for that I am forever grateful. Most of all, they have given me all that I need and more than I ever wished for in life.

Introduction

When I started my consulting company, Basel Analytics Inc.; I created a logo that I felt would best serve my long-term objectives – "Bringing Basel II Your Bank". While bringing The Basel II Framework to one’s bank is generally considered a scientific or academic endeavour, bringing one’s bank to The Basel II Framework is a venture that combines both Art & Science.

The Use Test, completed in The Basel II Framework’s final edition (June 2006) crystallises the operational concerns deemed central to the success of the program. A BIS memo (see Appendix A) issued in September 2006 offers enhanced meaning to the Use Test by broadening the operational, governance and fiduciary impacts of the test. The existing Basel II paragraphs lay down a broad set of principles that give bankers sufficient freedom to execute strategies in line with their desired approach to the market.

A bank successful in implementing the Use Test will demonstrate that the models and governance framework that they have adopted will become core competencies via the origination, management and disposal of retail credit assets. Such banks will have displayed to their regulators that they have fully integrated the Pillar 1, 2 and 3 rigors proposed, and have now acquired compliance certification from their senior management, executive rank, Board and regulator.

The Basel II Framework by its very essence, mandates banks to adopt a risk-sensitive operational and governance framework via numerous credit, market and operational risk criterion. It weaves bank compliance through supervisory measures and detailed market disclosure into this prescribed lattice so as to enable a balanced approach to these endeavours.

The Basel II Framework elicits banks to tie provisions and capital to their own risk tolerance. While some banks may be loath to adopt some of The Basel II Framework’s more elemental designs, most in fact will discover that they have in fact been using these components for some time. At the end of the day, most bank departments must be engaged in such pursuits and thereby act as a cohesive unit in doing so.

I have decided to focus my book on the tenants that retail banks will likely have the greatest challenge complying with in carrying out the Use Test precepts. More importantly, I wish to address how banks can achieve their greatest project investment return by employing The Basel II Framework’s primary tools, i.e. the Probability of Default (PD), Exposure At Default (EAD), Loss Given Default (LGD) models, and in composite the Risk Weighted Asset (RWA) measure. I will also exploit the key measures, principal processes, and key balances & controls of The Basel II Framework in this context. These include model validation and stress-testing, capital adequacy reporting, expected and unexpected loss measures, audit and disclosure controls. This will help me demonstrate their inherent value in maximizing the bank’s bottom line and thereby optimizing the risk-reward relationship within their lending book of business.

It would have been quite possible to enlist every one of The Basel II Framework paragraphs, as being integral components of the Use test, but that would have meant this book would have been a general text instead of a specialized one. This treatise will serve Retail Credit Risk Management and Basel II professionals alike intent on bringing the pieces central to achieving Use Test compliance using the fundamental Basel II Framework tools, into the areas of Marketing, Underwriting, Account Management, Portfolio Management, Recoveries, Provisioning and Capital reserve setting.

Banks require effective credit processes and strategies in order to use these tools throughout the credit cycle. I will set out to deliver such a framework, based on my many years of credit risk management experience. This framework will provide banks with an opportunity to maximize their credit risk yields by optimizing the risk-reward relationship using the PD, EAD, LGD and RWA parameter estimates. I contend that banks can enhance their existing profitability and thus exceed existing hurdle rates, making the business of granting credit a more profitable pursuit, while at the same time being Basel II Framework compliant.

The Use Test allows banks to not only use these new model estimates for existing credit processes, but further encourages banks to explore the full realm of all Pillar 1, 2 and 3 features within their lending, supervision & governance and public disclosure domains. I am certain that you will find this text at the very least innovative in expanding the boundaries from where you currently operate today. In fact, you may discover some techniques that may have brought about improved bank profitability returns in your old traditional credit cycle processes. Nowhere is this more important than within the realm of optimizing economic and regulatory capital. This scarce resource must be justly managed so that banks are still able to invest capital into ventures that will yield maximum yields while simultaneously demonstrating to their banking regulator that they continue to exhibit sound fiduciary practices.

This text is uniquely focussed on addressing the needs of banks involved in retail credit granting. While all of the major banks world wide offer retail banking products, most will not spend a great deal of attention attempting to demonstrate the Use Test in this area. Wholesale and corporate banking generally occupy higher levels of invested capital and therefore possess greater amounts of money at risk. There is far more evidence in the practitioner’s purview that Basel II Framework research seems to be far more focussed on wholesale credit than of that on the retail side. No doubt, that with far more credit at stake, the risk management practitioner’s efforts require far greater precision on the wholesale side. I therefore suggest that this book be dedicated to all of the credit unions, savings & loans and building societies in addition to the retail divisions of major banking entities, so that they too can see the overall benefit of a risk-sensitive credit granting operation within their confines.

Stephen D. Morris

Principal

Basel Analytics Inc

January 2008

Part I:

The Basel II Framework and the Use Test

This section refers to the definition of the Use Test. It illustrates the facets of the Use Test with particular attention to the specific Basel II Framework paragraphs providing the rules of adherence. These tools offer the reader a useful prescription for ensuring that their bank covers the necessary bases when pursuing its AIRB Basel II Framework compliance measures. Finally, it puts into the proper context where banks should be concerned in their pursuit of the ability to use these measures while pursuing the Use Test.

(i) The Basel II Framework

There is no doubt that the entirety of this book could be devoted to each and every paragraph of The Basel II Framework, as in principal banks must demonstrate compliance with each one relating to their product offerings. I however have taken the tact that while it is important to paint a picture of how each Basel II Framework measure has come about (as I have done at a fairly fundamental level, see Fig. 1 below); nevertheless this text will be dedicated to a different pursuit. The objective of The Basel II Framework is to provide banks with a blueprint so that they have tangible means to address risk at an enterprise level. The outcome of a Basel II Framework compliant bank will be one with policies, processes and practices that are risk sensitive, yet at the same time profitable. Were each bank to aspire to these goals, the net result would be the promotion of a more fiscally healthy financial services industry overall.

The Basel II Framework is divided into three pillars:

(i) Pillar 1 – Minimum Capital Requirements

(ii) Pillar 2 – Supervisory Review

(iii) Pillar 3 – Market Discipline

Parts II, III and IV of this book will go into greater detail regarding the actual Basel II Framework compliance measures. At this point what’s important are the key deliverables from each of these three pillars. In an abridged form they include the following components. In graphical form, they can be represented in Fig. 1.

(i) Pillar 1:

• PD, EAD and LGD models;

V00_9781434373014_TEXT.pdf Model Development,

V00_9781434373014_TEXT.pdf Model Validation,

V00_9781434373014_TEXT.pdf Model Stress-testing

• RWA setting for collateral and guarantees

• Operational Risk capital

• QIS

• Basel II Capital Adequacy Reporting

(ii) Pillar 2:

V00_9781434373014_TEXT.pdf Market Risk

V00_9781434373014_TEXT.pdf Credit Policy

V00_9781434373014_TEXT.pdf Balance and Controls processes

V00_9781434373014_TEXT.pdf Bank – Regulator communication

(iii) Pillar 3:

V00_9781434373014_TEXT.pdf Disclosure procedures for risk, capital adequacy and financial reporting

V00_9781434373014_TEXT.pdf Audit

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Fig.1 Basel II Framework

(ii) What is the Use Test

Although the Use Test can be encapsulated in paragraph 444 (see Appendix A: The Use Test) of The Basel II Framework, there are several other paragraphs alluding to adjoining concerns of the Use Test. This text focuses on unravelling the wide range of issues encompassed in these paragraphs, while exploring effective strategies for maximizing the bank’s returns from such a project’s investment via money, technology and resources.

Banks should not feel intimidated or threatened over the degree of Basel II precepts that must be integrated into their operations. Regulators in North America are sensitive to banking concerns towards implementing tools with little or no track record. Regulators also recognize the learning curve that banks must traverse throughout their enterprise with regards to both departments and staff, management, executive and board ranks. There is a lot of information to absorb and even more to both make sense and disseminate into existing policies and practices. Implementing such Basel II Framework precepts into a banking environment which in most cases has only accepted Risk Adjusted Return On Capital (RAROC)1 methodologies in recent years will bear some scepticism. Adopting recently devised and essentially time-untested models so soon after development with little time for validation and stress testing also will require a large degree of courage and ingenuity.

Nevertheless, if integration and implementation are the call to order of the day, a structured plan composed of details developed by an experienced and confident risk management staff is essential. Incorporating all of the necessary paragraphs relating to The Basel II Framework’s Use Test while still maintaining established capital hurdle rates, portfolio credit quality standards and overall profitability in addition to developing new products and services leading to shareholder content and corporate profitability sounds like an impossible challenge. The good thing however is that every other bank wanting to reach and maintain an Advanced Internal Ratings Based (AIRB) approach must reach this milestone. The challenge might therefore appear to be in knowing how to reach the balance of opinions posed by senior management, executives, Board, audit and the regulatory bodies in a cohesive sustainable fashion. The graphic below depicts the Use Test’s fundamental assertions, which banks must conform with.

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Fig. 2 Use Test Minimum Requirements

(iii) Use Test Minimum Requirements

The Use Test identifies several elemental requirements. It is these requirements that this chapter will focus on. I wish to expound on their primary goals, and thus they will be dealt with here in a theoretical fashion. Although the Use Test has been highlighted in several BIS papers, it is The Basel II Framework in its entirety, which lays out a large palate of tools and techniques for banks to partake in throughout their operations. While this chapter provides at a high level the minimum Use Test requirements, it is Parts II, III and IV of this book, which extrapolate the following key aspects of The Basel II Framework’s Use Test:

• The Credit Cycle according to The Basel II Framework, including the individual bank departments where compliance measures reside

• The tools that are used for estimating the Pillar 1 – Minimum Capital Requirements, and the application of these tools in carrying out the integration of key credit processes into the bank’s operational environments

The Use Test minimum requirements (Fig. 2) have been summarized into the following six groupings. I have extrapolated The Basel II Framework paragraphs most integral in explaining the scope of these requirements; found in sections a) – g) below. These sections will therefore highlight what the requirements entail. The remainder of the book will focus on which tools