Basel II Credit Risk Regulatory Compliance

The new Basel Capital Accord (Basel II) aims to improve the soundness of today's complex financial system by instituting regulatory guidelines that place more emphasis on banks' own internal controls for risk management. In recognition of international banks' varying levels of complexity and sophistication, Basel II provides a flexible structure in which banks can use their own systems to measure their market risks and, ultimately, to manage their businesses more effectively. Basel II offers a range of methodologies for the measurement of credit risk and operational risk in determining capital levels, so that banks can adopt approaches that best fit their risk profile. At the same time, it requires comprehensive disclosure by banks whose internal processes are subject to supervisory review and evaluation.

Risk-Weighted Capital has been adapted to help institutions to comply with Basel II requirements for credit risk management and regulatory reporting. You can use Risk-Weighted Capital to help perform risk-weighted asset and regulatory capital credit risk calculations as prescribed in the capital accords. It also enables institutions to benefit from compliance with Basel II by minimizing the amount of regulatory capital withheld, offering a significant competitive advantage. The PeopleSoft Enterprise Performance Management warehouse data structures have been expanded to store and process data in the areas of collateral, facilities, and customers. A new application engine has been created to support processing of portfolio data from end-to-end for each of four methods: standardized simple, standardized comprehensive, foundation, and advanced. You can also use delivered query reports to view online the results of the credit risk application engine, enabling you to categorize, analyze, and control your financial exposures.

Terminology

The following are commonly used terms and measurements calculated by the credit risk application engine for Basel II :

Term	Definition
PD	Probability of Default: the likelihood that a borrower will technically default on an obligation to repay a loan or other obligation.
LGD	Loss Given Default: expected loss in the event of default.
EAD	Exposure at Default: an on-balance sheet or off-balance sheet item is defined as the expected exposure of the facility upon default of the obligor at no less than the current drawn amount, subject to recognizing the effects of on-balance sheet netting.
EL	Expected Loss: the product of PD and LGD.
IRB	Internal Ratings Based: refers to the approach which allows banks to use their internal estimates of borrower creditworthiness to assess credit risk in their portfolios. The results are translated into estimates of EL, which forms the basis of minimum capital requirements. There are two variants to the IRB approach: foundation and advanced. See Credit Risk Processing Options.
CCF	Credit Conversion Factor: Used to calculate the credit exposure or EAD of off-balance sheet transactions in both the Standardized approach and Foundation IRB approach. Banks can use their own estimates for CCF in the advanced IRB approach.
Collateral	Risk mitigation instrument, especially financial instruments. The underlying security, mortgage, or asset for the purposes of securitization or borrowing and lending activities. In the case of securitized transactions, it means the underlying cashflows.
CRM	Credit Risk Mitigation: Reduction of credit risks by taking collateral, obtaining credit derivatives or guarantees, or taking an offsetting position subject to a netting agreement.
Customer Group	An institution-defined grouping of customers or counterparties associated with a credit facility. A customer group defines a list of customers or counterparties that can draw on a specific credit facility.
Haircut	Determined by the Basel Committee. Haircuts reflect the volatility of a loan, the financial collateral, and possibly existing volatility of currency. It is the margin (expressed in percent) applied to asset or liability exposures to reflect the volatility of that exposure.
Retail banking	Banking with private individuals, but can also include some type of small businesses.
Risk Rating	Represents the assessment of an individual person's or company's creditworthiness. All borrowers are assigned to rating categories in a standardized and consistent manner. The rating provides international investors with accepted standards as a basis for their investment decisions.
Maturity mismatch	Different maturities of exposure and risk mitigation instrument. The maturity of the risk mitigation instrument is shorter than exposure's maturity.
Headroom	Difference between the commitment amount on a credit facility and the summed draws against the facility.
Limit	Commitment amount of a facility (overall fund commitment made by the bank to the customer).
Product Group	An institution-defined grouping of financial products associated with a credit facility. A product group defines a list of products that a bank customer can contractually enter into under a specific facility agreement.
Sub-limit	Commitment amount limit of a sub-facility (that falls under the overall facility).
Sub-sub-limit	Commitment amount limit of a sub-sub-facility (a further restrictive limit which falls under a sub-limit)

Credit Risk Processing Options

There are four processing options for the credit risk engine using either the standardized approach or the Internal Ratings Based (IRB) approach:

Standard simple

The bank allocates a risk weight to each of its assets and off-balance sheet positions and produces a sum of risk-weighted asset values. A risk weight of 100% means that an exposure is included in the calculation of risk-weighted assets at its full value, which translates into a capital charge equal to 8% of that value. Similarly, a risk weight of 20% results in a capital charge of 1.6% (that is, one-fifth of 8%).

In support of the standardized simple approach, the credit risk application engine relies on configurable credit risk function rules to apply different weights to various exposure classes.
Standard comprehensive

Under the standard comprehensive approach, a bank can allocate eligible financial collateral to reduce the amount of the exposure to the counterparty. You can use regulatory or bank-defined haircuts to decrease the amount of collateral or increase the level of exposure. Haircuts account for potential changes in the market prices of securities and foreign exchange rates. Like the standardized simple option, risk weight factors are ultimately applied to the resulting net exposure.

In support of the standardized comprehensive approach, the credit risk application engine relies on a combination of collateral allocation and haircut algorithms, as well as configurable credit risk function rules.
Foundation (IRB)

The bank estimates each borrower's creditworthiness through an assigned risk rating and related PD (probability of default). These results, along with other inputs supplied by bank supervisors (such as LGD or Loss Given Default), are translated into estimates of a potential future loss amount, and minimum capital requirements.

Risk mitigants such as collateral and guarantees are treated very similarly to the standardized comprehensive approach. In support of the Foundation approach, the credit risk application engine relies on a combination of engine-assigned parameter values, collateral allocation, haircut algorithms and configurable functions.
Advanced (IRB)

The bank estimates the credit worthiness of borrowers as well as other inputs for the determination of potential future loss amounts and minimum capital requirements.

RWA and capital charge formulas are generally similar to the foundation approach, but allow banks more latitude in defining exposure estimates, probability of default and loss given default. The credit risk application engine incorporates this flexibility through its ability to read tables which contain factors such as LGD and PD.

Process Flow

The following table illustrates the process flow for credit risk processing.

Step	Activity	Description
1.	Load portfolio data.	Load facility, collateral and instrument data into the warehouse.
2.	Create processing scenario.	Define a standardized, foundation or advanced processing scenario.
3.	Load assumptions.	Load risk rating, PD, LGD (advanced) and risk-weight assumptions.
4.	Pool retail exposures (optional).	Group instrument level detail records into pools with like attributes.
5.	Define or alter risk function rules.	Rules can supplement or override delivered algorithms, risk weights.
6.	Run Credit Risk application engine.	Evaluates on and off-balance sheet exposures. Applies risk mitigation such as collateral or guarantees. Applies haircuts, maturity mismatch algorithms. Calculates facility headroom, optionally at sub-limit levels. Assigns PD, LGD, EAD and RW as appropriate. Applies risk functions.
7.	Review output.	Query output table to evaluate risk-weighted assets, regulatory capital results. Adjust and rerun as necessary.