Risk Management and Basel II
Basel II is primarily a set of guidelines (framework) for the supervision of capital. Most banks use an internal rating-based (IRB) approach to determine credit risk based on borrowers’ probability of default. During economic downturn losses on defaults are often greater than normal. Many banks seek to assess loss given default (LGD) on an exposure-byexposure basis (risk on a loan-by-loan basis). Most banks do not as yet assess risks on a portfolio basis.
In the banking world, there is a variety of practice with respect to the risk rating process, ranging from systems almost purely driven by statistical models, like credit scoring, to those based almost exclusively upon judgement. Generally three broad process categories can be discerned, according to the degree to which the risk rating is a product of mathematical models or of decisions of judgement (Grupo Santander 2000):
• ‘Statistical-based processes’
• ‘Constrained expert-based judgement processes’
• ‘Expert-based judgement processes’.
Credit risk is the risk of loss from the failure of a borrower to meet debt servicing and other payment obligations on a timely basis. Because there are many types of borrowers (individuals, small businesses, large businesses, sovereign governments and projects using project finance) and many types of facilities, credit risk takes many forms. However, there is a clear consensus that the credit risk associated with a loan depends on: