The Hindu Business Line : Models to watch before parting with money

THE Tower of Babel is what one would normally remember when amidst conclaves of accountants, because each one speaks a different voice, and they never agree. But Tower of Basel is where there is a lot of activity, because that is where the Bank for International Settlements (BIS) functions from. Even as near-sighted number-crunchers are worried about the CA Bill and bank audit allotment, CPE credit and new council members, a silent revolution is going on in the banking domain. It would be long before monolithic regulatory bodies wake up to educating their members about the upcoming changes, and so it would be advisable read a book such as Credit Risk Models and the Basel Accords by Donald R. Van Deventer and Kenji Imai, published by Wiley (www.wiley.com), to find out the sophistication that is creeping into major financial institutions.

Though, essentially, the Basel Committee is an exclusive club of central bank Governors of the Group of Ten countries, what is important is that it recommends statements of best practice. The "New Capital Adequacy Framework" or the Basel II Accord consists of three pillars: Minimum capital requirements; supervisory review of an institution's internal assessment process and capital adequacy; and effective use of disclosure to strengthen market discipline. It lays down three evolutionary variants to measure risks, namely, a basic standardised model, an internal rating-based (IRB) foundation model, and an advanced IRB model. Basel II is being operationalised sometime around end-2006.

The RBI has stated that the Accord represents "the convergence of research and practice in supervision as it attempts to apply state-of-the-art financial modelling techniques to the prescription of capital adequacy". For accountants who busy themselves with financial institutions, Basel is therefore something not to be lost sight of. What is the greatest strength of the Basel Committee's work? Its acknowledgment that "credit risk is the major risk facing modern global financial institutions," the authors Van Deventer and Imai point out. "Bankers have spent most of their time over the last four decades on only two questions." These are: Should I make this loan? Should I sell this loan and get rid of it? The book points out that this approach is too simplistic; also the questions lack context. Focussing on a simple `yes' or `no' would not help. The appropriate question, according to the authors, is: "Do I create more shareholder value on a risk-adjusted basis by keeping the transaction or disposing of it?"

The right credit modelling technology has to provide a lot more than just a default probability to be useful, they write. "We need a fully consistent methodology for pricing, valuation and hedging." What is interesting is that these three are linked, so if you have one, you would have the other two also. "If we know the pricing, we can calculate the value. If we can calculate the value, we can `stress test' the value with respect to key risk factors to obtain a hedge."

What is happening in India? On `supervisory review', the RBI has highlighted Risk-Based Supervision (RBS) and Prompt Corrective Action (PCA) in a recent report. Even as many fear that the Accord is too stringent for banks in emerging countries to follow, the SBI has committed itself to becoming a Basel-II compliant bank. Commendable because the SBI's international operations contribute about 6 per cent of its business, something far below the benchmark of 20 per cent that the RBI has stipulated for Basel-II compliance.

The book makes a strong case for deploying the right models to assess the risk-adjusted value of a borrower's promise to repay. "Such credit adjusted valuation can and should be used for all major derivate exposures, stand-by letters of credit, mark-to-market real time trade authorisations, net income simulation with default adjustment and so on."

One wonders if our traditional accountants would ever delve into these areas, because it is not uncommon to find bean counters unaware of even such simple things as `credit policy'.

BooksOfAccount@thehindu.co.in

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