Basel II simplifies management of credit portfolios, says BIS

Basel II will facilitate early detection of the quality of a credit portfolio because it allows for progressive estimation of the probability of default (PD) of borrowers, according to the Basel Committee on Banking Supervision.

“Banks will be able to recognise the performance of their credit portfolios way before an impairment or default has occurred. This is because the PD will increase with the poor performance of a loan and banks will not have to wait for recognition of an accounting loss to institute corrective measures.

“It is certainly good news to know that banks can stop a borrower from reaching a point of default by following their PD estimates, which the banks are required to establish under the internal ratings-based (IRB) approach. The basic fact is that deterioration in credit quality will be captured in the increase of the PD,” said a member of the Bank for International Settlements (BIS) secretariat.

Under the standardised approach, the quality of a credit portfolio is tracked by the results of credit ratings. “Banks can manage their credit portfolio more efficiently if they can act on a potential default before the PD actually gets to 100 per cent. This means you recognise it before it is recognised as an accounting loss,” the technocrat said.

He said this is a significant difference between Basel I and Basel II. “Under Basel I, the risk weights used cannot show the deterioration of the loans until they have been defaulted on.”

The BIS, in its September quarterly review, allayed fears that early recognition of changes in credit portfolio quality, and consequent changes in banks’ willingness to lend, could exacerbate the ups and downs of economic cycles or procyclicality.

“Under Basel I, a deterioration in the credit quality of a bank’s portfolio during a cyclical downturn is reflected in the bank’s capital adequacy ratio only at the last moment, at the time of the accounting recognition of the impairment. At that stage, banks often have no effective measures available to improve their capital adequacy ratios other than to stop extending new credit, which can in turn aggravate the downturn.

“In contrast, under Basel II, the deterioration of a portfolio should begin to be reflected in the bank’s capital adequacy ratio at a much earlier stage, and no further deterioration should occur in the capital adequacy ratio at the moment it is recognised as an accounting loss,” said the BIS.

The BIS said the new “common language” will not only provide early warning signals for banks and supervisors, but also provide essential information to investors about how risky the assets of securities issuers are.

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