The mortgage crisis of 2008 demonstrated the vulnerability of financial intermediaries towards extreme events emanating mainly from fragile risk management practices. Technically, financial intermediation is a pseudo derivative transaction, and banks take both long (loans) and short (deposits) position simultaneously. Therefore, the inherent risks in banking firms are extreme warranting a prudent risk assessment and management. The basic ingredient of risk management for commercial banks – capital adequacy ratio – is based on a regulatory driven standardised approach for calculation of capital adequacy. The standardised approach was proposed by Basel Committee on Banking Supervision as an interim arrangement and banks were expected to develop their own risk assessment systems. However, almost seven years after the second Basel Accord, banks in Pakistan are still relying on the risk weights provided by the central bank to assess and mitigate their overall risk. This standardised approach is seriously flawed with multiple caveats that should be of concern to commercial banks.
Primarily, the risk weights assigned under standardised approach for corporate sector are classified into rated (by approved rating agencies) and unrated exposures with different risk weights for investment (low) and speculative (high) grade entities. This must be interesting to note that none of the default in the last decade was detected ex ante by either of the two rating agencies in Pakistan (despite their claims that ratings are forward looking). Adding insult to injury is that some of the defaulted entities were enjoying investment grade status by these agencies, couple of weeks before declaring default and were ex post subsequently downgraded to default. This raises questions on prudence of risk mitigating practices that are based on such expert opinions. Therefore, if banks develop internal rating based models, they will be in better position to ex ante assess the likelihood of default and provide adequate capital cushion.
Similarly, for unrated corporate exposures, banks should allocate 100% risk weight for capital adequacy purpose. In Pakistan less than hundred industrial (excluding instrument ratings) firms have entity ratings as per the website of two local rating agencies. That would imply a 100 per cent capital charge by commercial banks for most of their corporate clients. This could be alarming as banks with credit portfolios skewed towards bad borrowers will be allocating less capital than required, exposing them to high default risk. This could also leads to Moral Hazard as capital charge for all unrated exposures is same, and banks might seek high risk borrowers to earn premium for augmenting their interest rate spread by hiding the risk under the rug. On the contrary, banks with premium quality unrated borrowers would managing a non-existing risk putting constraints on their capital. An internal rating base model can address these issues by classifying unrated borrowers according to their repayment capacity and consequently assessing appropriate capital for the relevant risks.
Lastly, standardised approach provides no benefits for diversification in portfolios which is a conventional tool for risk management. At present, banks are required to allocate risk weights to individual exposures regardless of the situation of their overall portfolio. Again, this might lead to the situation where banks will increase concentration of their portfolios to yield higher spreads, as they find no economic benefit from diversification. It is also important to note that diversification is not only diversifying one particular risk (intra diversification) but also applies to diversify the possible interaction of various risks (intra diversification) as market risk could trigger credit risk and credit risk could ultimately lead to market risk. None of these types of diversification are considered in standardised approach and banks with high concentration and low concentration will be on a similar pitch to allocate capital against contingent risks. The diversification impact is incorporated in Internal Rating Based (IRB) approach by assuming correlation of exposures within the portfolio for credit risk and under advanced management approach for operational risk, while in market risk, all value at risk models (under IRB) account for diversification.
Adapting internal rating based approach is beneficial both for commercial banks and the central bank. Commercial banks could have more accurate estimate of their exposures and can hedge only the relevant risk. This will mitigate the excess risk of bad borrowers and will free up capital against good borrowers, which can be used in other ventures. If the inherent risks are mitigated the economic cost of supervision for the central bank would be less and this would lower frictions in the financial system. SBP introduced a road map in 2005 to adopt internal rating based approach by January 2010 but unfortunately later they allowed flexibility for transition to internal models. Given, the risk management benefits from IRB, Commercial Banks should consider developing their internal assessment methodologies and SBP should follow up on adapting Basel II in its essence because otherwise we have seen that “one size fits all” approach is only good tp manage risk in a Gaussian World but could not sustain even a smallest black swan.
The author holds a PhD in Quantitative Finance from Paris Dauphine. He is Associate Professor of Finance at Lahore School of Economics and provides consultancy on risk management through Synergistic Financial Advisors.