Economic instability does not preclude banks from using IRB, finds FSI award winner

The construction of a Through-The-Cycle (TTC) rating system to assess credit risk in a developing country after it has experienced a financial crisis may enable banks to apply the internal ratings-based (IRB) approach, according to an award-winning paper by a research analyst in the prudential regulation department of the central Bank of Argentina.

Veronica Valles’ report, ‘Stability of a ‘through-the-cycle’ rating system during a financial crisis’, examined a country that faced a severe macroeconomic crisis, which then spread throughout the financial system. Valles argued that a TTC system, or a ratings system that remains relatively constant compared to a Point-In-Time (PIT) system, could make it possible for banks to use the advanced approaches despite economic instability.

Valles noted that Basel II requirements for long-run estimates of probability of default (PD) were more easily done in developed countries with stable economies. The task becomes difficult in emerging economies with periodic and severe shocks, she acknowledged, but this should not rule out the IRB approach.

“Difficulties do not have to discourage the implementation of Basel II in emerging economies. Limitations are going to be a challenge to supervisory authorities and financial institutions, which should make efforts to adapt the requirements to the specific conditions of the country,” Valles said. “The main objective of Basel II is to perform a more accurate management of risk in the banking industry, and this is a task that can certainly be accomplished,” she concluded.

The Financial Stability Institute (FSI) named Valles the winner of its FSI award at the International Conference of Banking Supervisors earlier this month. Click here to see the paper in full on the BIS website.

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