Credit Risk The key question of Basel II: What factors are driving credit risk?
• Estimation of the likelihood that the borrower will default
• Recovery rate if a borrower were to default
• Likelihood of a credit line being drawn upon
• Maturity of the loan
Standardized approach (credit risk) The term standardized approach (or standardized approach) refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions.
Under this approach the banks are required to use ratings from External Credit Rating Agencies to quantify required capital for credit risk. In many countries this is the only approach the regulators are planning to approve in the initial phase of Basel II Implementation.
The summary of risk weights in standardized approach
There are some options in weighting risks for some claims, below are the summary as it might be likely to be implemented.
NOTE: For some "unrated" risk weights, banks are encouraged to use their own internal-ratings system based on Foundation IRB and Advanced IRB in Internal-Ratings Based approach with a set of formulae provided by the Basel-II accord. There exist several alternative weights for some of the following claim categories published in the original Framework text.
• Claims on sovereigns Credit Assessment AAA to AA- A+ to A- BBB+ to BBB- B+ to B- Below B- unrated
Risk Weight 0% 20% 50% 100% 150% 100%
• Claims on the BIS, the IMF, the ECB, the EC and the MDBs Risk Weight: 0%
• Claims on banks and securities companies Related to assessment of sovereign as banks and securities companies are regulated
Credit Assessment AAA to AA- A+ to A- BBB+ to BBB- B+ to B- Below B- unrated
Risk Weight 20% 50% 100% 100% 150% 100%
• Claims on Corporate Credit Assessment AAA to AA- A+ to A- BBB+ to BB- Below BB- unrated
Risk Weight 20% 50% 100% 150% 100%
• Claims on retail products: This includes credit card, overdraft, auto loans, personal finance and small business. Risk weight: 75%
• Claims secured by residential property Risk weight: 35%
• Claims secured by commercial real estate Risk weight: 100%
• Overdue loans More than 90 days other than residential mortgage loans.
Risk weight:
• 150% for provisions are less than 20% of the outstanding amount
• 100% for provisions are between 20% - 49% of the outstanding amount
• 100% with supervisory discretion to reduce to 50% for provisions are 50% and more of the outstanding amount
Other assets; Risk weight: 100%
• Cash: Risk weight: 0%
Credit Risk: The Standardized Approach Sovereign Means the central government, provincial government or the central bank of a country.
PSE Public sector entity (PSE) is one, which is owned or controlled by central or provincial government or any entity categorized as PSE by SBP.
Corporate “Corporate” refers to any proprietorship, partnership or limited company that is neither a PSE, Bank, DFI, nor borrower within the definition of regulatory retail exposures. For capital adequacy purposes, the term also includes insurance companies and securities firms. Under Standardized Approach, SMEs not fulfilling the conditions of the regulatory retail portfolio would also be considered as Corporates.
Past due An exposure is considered past due in whole if mark-up/interest on it or principal is overdue as per the prudential regulations as amended from time to time.
Retail The exposure to an individual person or persons or to a small business; and is in the form of revolving credits and lines of credit (including credit cards and overdrafts), personal term loans and leases (e.g. installment loans, auto loans and leases, student and educational loans, personal finance) and small business facilities and commitments. Mortgage loans are not included in this category. To be eligible, the total exposure to a single person;
o Should not be more than PKR 10 million both in cases of consumer loans and small business loans
Should not be more than 0.2% of total (gross) retail portfolio of bank.
Past due retail loans are to be excluded from the overall regulatory retail portfolio when assessing the granularity criterion of 0.2% specified herein, for risk-weighting purposes.
Residential Mortgage finance Loans fully secured against residential real estate. It includes loans provided to individuals for the purchase of residential house / apartment. The loans availed for the purpose of making improvements in house / apartment / land shall also fall under this category. Loans secured by residential real estate for business purposes and loans secured against commercial real estate do not fall under mortgage loans.
Core Market Participants Core market participants include the following entities: a) Sovereigns, central banks and PSEs;
b) Banks;
c) Other financial companies (including insurance companies) eligible for a 20% risk weight in the Standardized Approach;
d) Regulated mutual funds that are subject to capital or leverage requirements;
e) Regulated pension funds; and
f) Recognized clearing organizations.