Credit risk modelling: current practices and applications
21 April 1999
The Basle Committee on Banking Supervision today issued a report analysing the current practices and issues in credit risk modelling, a fairly recent methodology used by sophisticated financial institutions to quantify and aggregate credit risk across geographical and business lines. This report provides a description of current practices in credit risk modelling and assesses the potential uses of credit risk models for supervisory and regulatory purposes.
The report also notes that credit risk models offer a tailored and flexible approach to credit risk measurement and management. It concludes that models are an important tool in risk management as they provide estimates of credit risk that are influenced by and responsive to shifts in business lines, credit quality, market variables and the economic environment. The report discusses the range of practice in the conceptual approaches to modelling, including the choice of time horizon, the definition of credit loss and the various approaches to aggregating credits and measuring the connection between default events.
One of the issues raised in the report is the potential use of such models in determining regulatory capital requirements. The report notes that a number of hurdles, principally concerning data limitations and model validation, must be cleared before credit risk models can play a part in setting regulatory capital requirements for credit risk.
William McDonough, chairman of the Basle Committee and president and chief executive officer of the Federal Reserve Bank of New York, stated that he is encouraged by the advances in credit risk modelling and welcomes further work in this area. He also noted that credit risk modelling will play a critical role in risk management and that in the future, assuming that the hurdles discussed in the report can be overcome, it may also have a role in the determination of regulatory capital requirements.
In preparing this report, the Basle Committee's Models Task Force reviewed material culled from numerous public conferences and private presentations by market practitioners, and conducted an extensive survey of modelling practices at 20 banking institutions located in 10 countries. This review highlighted the wide range of practices in the methodologies used to develop the models and in the internal applications of the models' output. This exercise also underscored a number of challenges and limitations to current modelling practices including the following:
- Data limitations: the report notes that the ability of models to take into account the process of default and other factors leading to changes in credit quality is severely constrained by a lack of data on the historical performance of loans and other variables. The difficulties in these specifications are exacerbated by the longer time horizons used in measuring credit risk, as compared with market risk, which suggests that many years of data, spanning multiple credit cycles, may be needed to estimate key parameters accurately.
- Model validation: the report notes that to gain further confidence in credit risk modelling, both banks and regulators need some means of ensuring that a bank's internal models accurately represent the level of risk inherent in their portfolio. However, the issue of longer horizons makes it fundamentally more difficult to validate credit risk models than market risk models. The report notes that, at present, there is no commonly accepted framework for periodically verifying the accuracy of credit risk models.
Ms Daniele Nouy, Secretary General of the Basle Committee, and Chair of the Models Task Force said that "the Committee welcomes additional efforts in addressing these and other key issues and hopes to engage the industry in a constructive dialogue going forward." The Committee is seeking comments on this report from all interested parties by 1 October 1999.
The report also considered the potential uses of credit risk models for supervisory and regulatory purposes, including the determination of regulatory capital requirements. Ms Nouy said that "a models-based approach to regulatory capital might bring capital requirements into closer alignment with the riskiness of a bank's assets, and produce estimates of credit risk that better reflect the composition of each bank's portfolio." However, the report notes that before a portfolio modelling approach could be used to determine capital requirements for credit risk, regulators would have to be confident not only that models are being used to actively manage risk, but also that they are conceptually sound, empirically validated, and produce capital requirements that are comparable across institutions.
Notes for Editors
The Basle Committee on Banking Supervision
The Basle Committee on Banking Supervision is a committee of banking supervisory authorities established by the central bank Governors of the Group of Ten countries in 1975. It consists of senior representatives of bank supervisory authorities and central banks of Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States. Its current chairman is Mr William J McDonough, President of the Federal Reserve Bank of New York. The Committee usually meets at the Bank for International Settlements (BIS) in Basle, where its permanent Secretariat is located.
The Models Task Force
The Models Task Force was set up by the Basle Committee in 1994, and consists of supervisory experts from member institutions of the Basle Committee. It is chaired by Ms Daniele Nouy, Secretary General of the Basle Committee. The foundation for the Task Force's review of credit risk models includes material culled from public conferences and private presentations by market practitioners, including banking institutions, model vendors and researchers. The report is also based on the results of an extensive survey conducted by the Task Force of modelling practices at 20 international banks located in 10 countries.
Where can I obtain the full report?
The report, "Credit Risk Modelling: Current Practices and Applications," can be obtained from the BIS website (www.bis.org) as of 16:00 (CET) on 21 April. The report is also available from the Basle Committee's Secretariat at the BIS and from member bank supervisory authorities and central banks.