Fitch enhances analysis of banks' risk-based capital

Credit rating agency places new emphasis on using op risk as a rating element

LONDON - Fitch Ratings has introduced a new quantitative tool aimed at enhancing its analysis of bank regulatory capital adequacy. The new risk data and calculation tool ('risk calculator') reflects the advance in industry use of risk-based capital models that has been supported by the introduction of the Basel II capital framework.

Fitch has completed initial testing of the risk calculator tool, and released a special report - 'Regulatory Capital Ratios: A Case Study' - on August 10 that uses data from a group of Scandinavian banks to illustrate Fitch's approach to meeting the challenges in analysing Basel II risk and capital data.

The major Scandinavian banks were early adopters of Basel II, and their participation in the testing phase of Fitch's risk calculator has enabled Fitch to evaluate its risk calculator against a broadly comparable peer group.

The risk calculator facilitates the collection of improved bank risk exposure data in a standardised format. It enables Fitch to determine regulatory capital at individual asset class and aggregated levels, evaluate risk exposures by estimating risk weights and analyse underlying risk parameters - probability of default (PD) loss given default, exposure at default, maturity and risk-weighted analysis - at asset class level.

The systematic collection of relevant data will enable Fitch to perform peer analysis of risk parameters, identify patterns or trends in risk profile, compare capital requirements across Basel II approaches and estimate the effect of stressed economic conditions through sensitivity analysis of individual risk parameters.

At the moment, the calculator captures credit risk only, as this remains the dominant driver of risk-based capital at most banks, but as operational risk increases, particularly in large complex institutions, the final version of the tool is expected to include high-level data for market and operational risk, high-level Pillar 2 risk data and a comparison of Fitch-defined versus regulatory capital.

While the risk calculator provides a valuable quantitative framework for bank analysts, the agency warns it is important to reconcile or contextualise the data within a broader analysis of the institution's risk appetite, asset quality, portfolio-level concentrations and credit culture. A review of the institution's risk rating and quantification methodologies, processes and validation practices is also stated as being helpful in providing comfort regarding the rigour and credibility of the resulting risk estimates.

Fitch expects to refine the risk calculator during the remainder of 2009, and aims to roll it out to a larger number of banks in 2010. As more data is collected, Fitch expects to be able to benchmark specific risk estimates across multiple asset classes and different peer groups. As additional information is gathered and results are evaluated, Fitch expects to publish regular supporting research in line with its commitment to provide relevant and timely commentary on central industry topics.

Fitch's report, 'Regulatory Capital Ratios: A Case Study' is available via its website, here.