Adoption of Basel III IRB Approach is essential for Long Term Financial Stability for our Banking System

Background

Risk taking is a natural part of banking transactions; the regulatory agency is responsible for creating a sound financial environment by setting the regulatory framework where the supervisory agency monitors the financial viability of banks and checks compliance with regulations. The pitfalls associated with the regulatory capital requirements (cherry picking-capital arbitrage) led to the development of more risk based or economic capital based Basel III IRB approach. Banks in India are now facing challenges to devise sustainable long term business plans to cope with the rising NPA problems due to Covid19 crisis.  In this context, combining the principles of risk management with those of shareholder analysis will allow the lenders to exploit the strengths of each for better strategic planning. An effective risk management framework makes bankruptcy less likely, by making senior management aware of the volatility of overall cash flows. It reduces the cost of financial distress and gives a bank better access to capital markets. 

The introduction of Basel norms has incentivized many of the best practices banks to adopt better risk management techniques and to reconsider the analyses that must be carried out to evaluate their performance relative to market expectations and relative to competitors. Broadly speaking, the objectives of Basel III are to encourage better and more systematic risk management practices, especially in the area of core risks (credit, market and operational), and to provide improved measures of capital adequacy for the benefit of supervisors and the marketplace more generally. The Basel III reforms focuses on enhancing capital adequacy, improving liquidity and reducing systemic risks in banking systems have been adopted by banking regulators world over including the Reserve Bank of India.

Under the internal rating based approach (IRB), regulatory Capital requirements are more in line with Economic Capital requirements of banks and by this, make capital allocation of banks more risk sensitive as banks will have to use their PD, LGD estimates along with Asset Correlation assigned by the regulator to give importance to macroeconomic effects as well.  Under IRB, banks will be able to assign economic capital to transactions, products, customers, business lines and organizational units in a systematic way. IRB based regulatory capital can be consistently applied across a wide variety of diverse risky positions and portfolios allowing the relative importance of each to be directly compared and aggregated. It requires internal definition and quantitative measurement of risks at the bank level and the capital required to support such risks at bank level (top-down vs. bottom up approach). 

Basel III Update: 

In December 7, 2017, Basel Committee for Banking Supervision (BCBS) has made significant Risk Weighted Assets (RWAs) reforms to enhance robustness and risk sensitivity of the standardized approaches for credit risk. A time line has been given to banks to adopt more risk sensitive and sophisticated Internal Rating Based Approaches (IRB) in a phased manner. This has been further consolidated in the year 2019. The Final Basel III Accord encourages advanced risk management capabilities by stipulating three levels of increasing sophistication in credit risk capital charge. The revised standardized approach (RSA) has been brought in to enhance robustness and risk sensitivity of the standardized approaches for credit risk. It has reduced mechanistic reliance on External Credit Rating Agencies (ECRAs). Under RSA, approach, banks are required to use credit ratings to conduct sufficient due diligence in lending. The IRB approaches use different methods to calculate Probability of Default (PD), Loss Given Default (LGD) and Exposure at Default (EAD). The IRB approach has two variants, Foundation IRB and Advanced IRB. Under FIRB, banks internally determine the Probability of Default (PD) for different loan exposures subject to certain regulatory conditions. Under AIRB, banks can internally estimate PD, LGD and EAD using their internal data subject to certain regulatory floors. Globally, the IRB framework has proven its validity as a risk sensitive way of measuring capital requirements (BCBS, 2016). In USA, large banks (asset size over USD 250 billion) that use an IRB approach are already subject to additional credit risk capital requirements. Large US banks have been operating under Basel III since 2014. Under the Collins Amendment, US banks calculate credit RWAs under both the IRB as well as Standardized Approach and are bound by the approach that yields a higher value for Risk Weighted Assets (Review of Banking and Financial Law, Vol. 36, Spring 2017, page 508). More interestingly, IRB regulatory formula focuses on range of PD, LGD and Correlation numbers and their distributions rather their average fixed values. 

Portfolio Credit Risk and Importance of IRB Parameters in Banking: 

Table 1 summarizes portfolio risk position of major Scheduled Commercial Banks in India in terms of credit risk and capital. Average probability of default (PD) is the long run average of their fresh slippage rate that has been estimated from the movement of Non-Performing Assets (NPAs). Fresh slippage rate (or marginal PD) in a year is the ratio of additions in Gross NPAs to the 3 year moving average of gross advances. Unexpected Loss (UL%) is the standard deviation fresh slippage rate. Single Default Correlation (DC) is estimated from the ratio of variance of UL to variance of PD. Default correlation captures the concentration risk in the banks’ credit portfolio. Higher the value of DC, greater will be the spike in fresh slippage rate due to joint default risk amongst the borrowers. The increased in joint default incidents lead to clustered defaults which increase the unexpected increase in the GNPA slippage rate of banks. Asset correlation has been extracted using Bluhm and Overbeck (2003 & 2007) variance function and joint default probability function. Asset correlation (AC) captures the common systematic factor. It is a key regulatory parameter in the calculation of the capital charge for credit risk under the IRB framework. Higher asset correlation captures the influence is single common risk factor (or macroeconomic effect: in the event of an economic crisis, all assets will be affected adversely). Correlations between assets reveal how the asset value of a borrower depends on asset value of another borrower. Generally, asset correlation (AC) value is higher than the default correlation (DC). Default correlation only focuses on joint occurrence of defaults if asset values fall significantly. It is used to estimate the economic capital of a bank. The asset correlation is used to estimate regulatory capital using a credit value at risk method prescribed by the Basel committee. It is quite evident from Table 1 correlation figures that generally, bigger banks have more diversification effects. This is in line with the BCBS 2017 IRB assumption. Note that these correlation numbers are indication of their sensitivity to systematic common risk. Higher the asset correlation value, greater the chance that due to systematic factor there will be increase in the fresh slippage rate.  However, as long as bank has enough tier 1 capital and good governance, they can absorb higher unexpected risk due to such high correlation to systematic risk. So a holistic portfolio review by senior management is essential for better capital planning. 

Table 1: Portfolio Risk Position: Default and Asset Correlation of Major SCBs in India, 2003-2018

Source: Authors own computation from the disclosed Audited Annual Reports of SCBs. Tier 1% is obtained from FY 2018-19 Basel III disclosures of Banks. As per the Basel 3, banks will have to keep minimum 7% as tier 1 capital to their risk weighted assets. If we include capital conservation buffer (CCB), the minimum would be 9.50% by 31st March 2020. 

Concluding Discussions: 

The IRB capital formula is very sensitive to Probability of Default (PD), Loss Given Default (LGD) and Correlations since these indicators are the major drivers of inherent credit risk in a systemically important bank’s loan portfolio. By permitting more risk sensitivity to credit risk weighted assets, Basel III IRB approach will enable the senior management of banks to appropriately set their risk appetite and undertake conscious credit planning. Graduating towards more sophisticated IRB framework requires enough time for preparation and developing essential data infrastructure and implementation timeline. Keeping in view of this and overall Covid19 pandemic situation, BCBA has recently extended its Basel III implementation timeline for advanced approaches till 2023. Since Indian banks are becoming larger owing to consolidation and also due to increase in business size, a more sophisticated internal rating based approach is necessary to be adopted to allow greater risk sensitivity of their lending assets. This will ensure better and more efficient allocation of scarce capital. An effective forward looking credit risk management framework will not only improve the banks’ underwriting standards but also enable them to accelerate growth and enhance risk adjusted performance on a continuous basis in a post covid19 business environment. Sophistication in the data management system, use of digital platform, improvement in risk analytical techniques and their usage in banking will play vital role in this new challenging business environment. However, without direct involvement and ownership of top management, IRB implementation is not possible.