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Basel 2 Preparation and Bank Credit Ratings Taipei, June 2005. Terry Chan, CFA Regional Criteria Officer, Asia-Pacific Standard & Poor ’ s Ratings Services. Basel 2 Preparation & Bank Ratings Agenda . Basel 2 and the bank rating process:
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Terry Chan, CFA
Regional Criteria Officer, Asia-Pacific
Standard & Poor’s Ratings Services
Basel 2 and the bank rating process:
How do rating agencies perceive the region? How do they look at Asia-Pacific?
What factors are considered for upgrading or downgrading a bank?
How will the rating process be affected by Basel 2?
Source: Part of contents was sourced from Standard & Poor’s report titled: ‘Basel II: Australia and Singapore Lead Asia-Pacific in Preparations’ published on March 1, 2005. To arrange for a copy, please phone Standard & Poor’s RatingsDesk, Hong Kong, (852) 2533-3500.
Economic & Industry Risk – Asia-Pacific Banking Systems (scatter diagram of risk profiles)
However, potential capital reductions are debatable for many Asia-Pacific banking systems; capital requirements may be unchanged or increase.
- In Australia, limited scope for material decrease at current rating levels.
- In Japan, limited downward effect on capital levels of majority of banks.
- Other countries, effect less clear, because of data collection difficulties.
Standard & Poor’s ratings analysis on financial institutions focus on a variety of business and financial risk factors.These include:
Business profile risks
Higher economic risk of country in which the bank operates, the higher the capital need because of volatility.
Higher industry risk of system in which the bank operates, the higher the capital need because of contagion and bank counterparty risk.
Indirect benefit. Better position allows bank to be more of price-maker than price-taker. Slightly reduces capital need.
In theory, lowers volatility of earnings and credit losses; should lower capital need.
Lack of management depth and/or aggressive strategy implies higher risk and thus higher capital need.
Financial profile risks
Higher credit risk of a bank’s book, the higher the capital need.
Higher market risk of a bank’s book, the higher the capital need.
The less ‘sticky’ the funding, the more a bank has to rely on capital as funding source and to allay depositors’ concerns.
The more volatile and more risky the earnings, the more capital is required.
Superior risk management would anticipate and reduce volatility and losses, implying less capital is needed.
ACE and ATE are measured as a proportion of a number of denominators to derive a series of capital ratios.
NO ONE RATIO IS THE PERFECT CAPITAL RATIO
Rather Standard & Poor’s looks at a number of ratios to determine the true capital position for a rated institution.
In general, about the process:
Steps in the ratings process remain the same.
Higher demands from regulators and financial markets for banks to comply with Basel 2.
Because a competitive position is relative, a bank’s inability to comply while other banks are doing so means the bank’s relative profile has weakened.
As credit ratings are meant to differentiate credit risk among issuers, the bank that falls behind its peers in terms of risk management and risk management systems may see the relative position of the credit rating on the bank fall.
Standard & Poor’s expects every bank to continuously improve itself, regardless of developments outside the bank (e.g. Basel 2). If a bank does not do so, it is indicative of a management team lacking foresight.
Basel 2 requires a bank to look into these areas:
- credit risk (under Pillar 1)
- operational risk (under Pillar 1)
- trading risk (under Pillar 1)
- continuing cooperation with supervisor (Pillar 2)
- disclosure (Pillar 3)
Standard & Poor’s expects the credit risk management system of a bank to match the complexity of its credit book.
For example, a bank extending project finance is likely to require have a more specialized credit assessment procedures and systems.
A bank with operations outside the domestic market should have more sophisticated credit risk management systems.
It always comes back to whether bank management is:
i) aware of,
ii) understand, and
iii) is able to manage
the risk. Of course, the reward-for-risk should be there.
Like credit risk, the operational risk management system of a bank to match the complexity of its operations.
Bank operations are mostly domestic and so operational risk should be quite straightforward.
Like credit and operational risk, the trading risk management system of a bank to match the comparative complexity of its trades.
Comparative complexity refers to the complexity compared to the bank’s mainstream operations and risk management systems. For example, an interest rate swap may be common to a bank but new to another almost identical peer bank.
Standard & Poor’s has concerns that second and third tier domestic players in foreign exchange and swaps markets do not fully appreciate the risks and lack the flexibility of accessing markets.
Standard & Poor’s will look to see if such players can afford the necessary risk management systems to support such trades.
Supervisory review (Pillar 2):
The Internal Ratings-Based (IRB) approach, particularly Advanced IRB, requires a high degree of resources and skill sets at the regulatory authority to verify the systems.
If the regulatory authority is not provided the resources to do so, it would be difficult for Standard & Poor’s to accept at face value a bank’s introduction of an IRB system.
That is to say, Pillar 2 is not fully in place.
Disclosures (Pillar 3):
The better a bank is able to improve its disclosures, the more likely it is that the bank has the information and risk management systems to measure exposures and risk.
(Admittedly this is not always the case.)
Standard & Poor’s expects that this area may develop a little slower than Pillars 1 and 2 as banks and regulators initially focus on the other two Pillars.