District Circular Letters
May 14, 1999
BANKING SUPERVISION AND REGULATION:
BASLE REPORT ON CREDIT RISK MODELING
Y2K CUSTOMER CHECKLIST and CONTINGENCY PLANNING
To State Member Banks, Bank
Holding Companies, Edge Act Corporations,
U.S. Branches and Agencies of Foreign Banks,
and Others Concerned
in the Twelfth Federal Reserve District
Current Practices and Applications in Credit Risk Modeling
The Basle Committee on Banking Supervision has issued a report analyzing
the current practices and issues in credit risk modeling, a fairly recent
methodology used by sophisticated financial institutions to quantify and
aggregate credit risk across geographical and business lines. This report
provides a description of current practices in credit risk modeling and
assesses the potential uses of credit risk models for supervisory and
regulatory purposes.
The report also notes that credit risk models offer a tailored and flexible
approach to credit risk measurement and management. It concludes that
models are an important tool in risk management as they provide estimates
of credit risk that are influenced by and responsive to shifts in business
lines, credit quality, market variables and the economic environment.
The report discusses the range of practice in the conceptual approaches
to modeling, including the choice of time horizon, the definition of credit
loss and the various approaches to aggregating credits and measuring the
connection between default events.
One of the issues raised in the report is the potential use of such models
in determining regulatory capital requirements. The report notes that
a number of hurdles, principally concerning data limitations and model
validation, must be cleared before credit risk models can play a part
in setting regulatory capital requirements for credit risk.
William McDonough, chairman of the Basle Committee and president and chief
executive officer of the Federal Reserve Bank of New York, stated that
he is encouraged by the advances in credit risk modeling and welcomes
further work in this area. He also noted that credit risk modeling will
play a critical role in risk management and that in the future, assuming
that the hurdles discussed in the report can be overcome, it may also
have a role in the determination of regulatory capital requirements.
In preparing this report, the Basle Committee's Models Task Force reviewed
material culled from numerous public conferences and private presentations
by market practitioners, and conducted an extensive survey of modeling
practices at twenty banking institutions located in ten countries. This
review highlighted the wide range of practices in the methodologies used
to develop the models and in the internal applications of the models'
output. This exercise also underscored a number of challenges and limitations
to current modeling practices, including the following:
- Data limitations: the report notes that the ability
of models to take into account the process of default and other factors
leading to changes in credit quality is severely constrained by a lack
of data on the historical performance of loans and other variables.
The difficulties in these specifications are exacerbated by the longer
time horizons used in measuring credit risk, as compared with market
risk, which suggests that many years of data, spanning multiple credit
cycles, may be needed to estimate key parameters accurately.
- Model validation: the report notes that to gain further
confidence in credit risk modeling, both banks and regulators need some
means of ensuring that a bank's internal models accurately represent
the level of risk inherent in its portfolio. However, the issue of longer
horizons makes it fundamentally more difficult to validate credit risk
models than market risk models. The report notes that, at present, there
is no commonly accepted framework for periodically verifying the accuracy
of credit risk models.
Ms. Daniele Nouy, Secretary General of the Basle Committee and Chair
of the Models Task Force, said that "the Committee welcomes additional
efforts in addressing these and other key issues and hopes to engage the
industry in a constructive dialogue going forward."
The Committee is seeking comments on this report from all interested parties
by October 1, 1999.
The report also considered the potential uses of credit risk models for
supervisory and regulatory purposes, including the determination of regulatory
capital requirements. Ms. Nouy said that "a models-based approach to regulatory
capital might bring capital requirements into closer alignment with the
riskiness of a bank's assets, and produce estimates of credit risk that
better reflect the composition of each bank's portfolio." However, the report
notes that before a portfolio modeling approach could be used to determine
capital requirements for credit risk, regulators would have to be confident
not only that models are being used to actively manage risk, but also that
they are conceptually sound, empirically validated, and produce capital
requirements that are comparable across institutions.
Financial Regulatory Agency Y2K Checklist
The financial agencies have issued the enclosed publication, "A
Y2K Checklist for Customers." The release includes a series of actions
consumers are encouraged to take to protect themselves during the Year 2000
rollover. The checklist is another tool that the agencies have developed
as part of their customer awareness program. Customer awareness programs
are a critical means of ensuring customer confidence in their own financial
institutions and the U.S. banking system in general. We encourage institutions
to reproduce the checklist and make copies available to their customers.
FFIEC Q&A on Y2K Contingency Planning
The Federal Financial Institutions Examination Council (FFIEC) has issued
additional answers to three frequently asked questions regarding Year 2000
contingency planning. The enclosed "Q&A
on Contingency Planning" clarifies the FFIEC's expectations concerning
the completion of the validation phase of business resumption contingency
planning by June 30, 1999, documentation requirements, and the role of "event
planning" in the development of business resumption contingency plans. It
is an addition to the original FFIEC Q&A Document issued in December
1998.
FFIEC guidance issued last year states that financial institutions should
complete business resumption contingency plans, along with a method to test
these plans, by June 30, 1999. Today's guidance states
that financial institutions may execute tests of business resumption contingency
plans after June 30, 1999, but early enough to allow ample time to make
necessary changes and to retest the business resumption contingency plans,
if necessary. A qualified and independent party should review the business
resumption contingency plans and validation method. In addition, senior
management and the board of directors should review and approve the business
resumption contingency plans and the validation method by June 30, 1999,
or shortly thereafter.
The guidance defines "event planning" as a proactive and detailed planning
process that covers specific operations prior to and during the century
date change. "Event planning" entails monitoring and detecting problems
and resolving issues related to whether and how to implement business resumption
contingency plans. Event planning is a sound risk management practice that
can make Year 2000 business resumption contingency plans more effective.
The FFIEC encourages, but does not require, financial institutions to develop
event plans. The guidance states that operationally complex institutions
or institutions that are especially vulnerable to Year 2000-related risks
should give special consideration to developing event plans.
Copies
The report, "Credit Risk
Modeling: Current Practices and Applications," can be obtained from
the Basle Committee's Internet site. Copies are also available from our
Corporate Services Department. To request copies of the report to be sent
via mail, please call (415) 974-2748. A pdf file of "A
Y2K Checklist for Customers" is available on the Board of Governor's
Internet site. The FFIEC "Q&A
on Contingency Planning" is also available via the FFIEC web site.
Additional Information
For additional information regarding these matters, please contact our Banking
Supervision and Regulation Department, at (415) 974-3177
[for the report on credit risk modeling], and (213) 683-2738
[for the Y2K Checklist and FFIEC Q&A].
FEDERAL RESERVE BANK OF SAN FRANCISCO
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