Basel II aims at creating an international standard to determine the minimum capital allocated by banks to guard against different types of risks exposures. The revised guidelines address credit risk, market risk and operational risk. The capital required by the bank to safeguard its solvency and economic stability is directly proportional to the aggregated risk it carries.

Basel Accord has laid down the following three pillars in order to help banks protect themselves from unexpected losses:

• Minimum capital requirements (addressing risk) deal with maintenance of regulatory capital calculated for three major components of risk that a bank faces.
• Supervisory review deals with the need to review minimum capital at regular intervals by Supervisors; helps in incorporating risks not yet captured – Legal Risk, Liquidity Risk, Reputation Risk.
• Market discipline is aimed at greatly enhancing the disclosures that the bank must make to the market.

Challenge

Banks are facing the biggest challenge in arriving at the credit risk as defined in the first pillar. Banks have a choice of adopting between two broad methodologies for calculating their credit risk—Standardized Approach and Internal Ratings Based Approach.

While going for standardized approach means using the credit ratings provided by external credit assessors, Internal Ratings Based Approach (IRB) is based on internal ratings. Credit Risk in IRB Approach is measured in terms of Expected Loss. Expected Loss is directly proportional to the following:

• Probability of Default - What is the probability of a lender going into default?
• Exposure at Default - How much will that customer owe the bank in the case of default?
• Loss Given Default - How much of that exposure is the bank going to lose?

Expected Loss = Probability of Default (PD)* Loss Given at Default (LGD) *Exposure at Default (EAD)

There are two different approaches in IRB.

• Foundation IRB approach allows banks to develop their own empirical model to estimate the PD (Probability of Default) for individuals or groups and the values of EAD (Exposure at Default), LGD (Loss Given Default) are guided by the regulator.
• Advanced IRB approach lets banks develop their own empirical models to estimate PD (Probability of Default), EAD (Exposure at Default), and LGD (Loss Given Default).

Inductis Solution

Inductis is helping international banks to comply with Basel II guidelines. Inductis has the experience across 11 countries, including US and UK and South East Asia over the entire life span of Basel II—development of models, validation of models, their implementation, and annual reviews. We have successfully created and implemented empirical models for all the three parameters— Probability of Default (PD), Loss Given at Default (LGD), and Exposure at Default (EAD)—required by a bank to measure its credit risk.

• Development of models
• Validation of models
• Model implementation
• Annual reviews

Advantages of Basel II

• Benefits customers with lower probability of default.
• Benefits banks to hold lower capital requirement if they have corporate customers with lower probability of default.
• Benefits SME customers to be treated differently from corporates.
• Benefits banks to hold lower capital requirement if they have credit card product customers with lower probability of default.