Assessing the Basel II internal ratings-based approach. Empirical evidence from Australia

Author:Silvio Tarca, Marek Rutkowski
Position:School of Mathematics and Statistics, University of Sydney, Sydney, Australia
Pages:106-139
SUMMARY

Purpose This study aims to render a fundamental assessment of the Basel II internal ratings-based (IRB) approach by taking readings of the Australian banking sector since the implementation of Basel II and comparing them with signals from macroeconomic indicators, financial statistics and external credit ratings. The IRB approach to capital adequacy for credit risk, which implements an asymptotic single risk factor (ASRF) model, plays an important role... (see full summary)

 
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Assessing the Basel II internal
ratings-based approach
Empirical evidence from Australia
Silvio Tarca and Marek Rutkowski
School of Mathematics and Statistics, University of Sydney,
Sydney, Australia
Abstract
Purpose – This study aims to render a fundamental assessment of the Basel II internal ratings-based
(IRB) approach by taking readings of the Australian banking sector since the implementation of Basel
II and comparing them with signals from macroeconomic indicators, nancial statistics and external
credit ratings. The IRB approach to capital adequacy for credit risk, which implements an asymptotic
single risk factor (ASRF) model, plays an important role in protecting the Australian banking sector
against insolvency.
Design/methodology/approach – Realisations of the single systematic risk factor, interpreted as
describing the prevailing state of the Australian economy, are recovered from the ASRF model and
compared with macroeconomic indicators. Similarly, estimates of distance-to-default, reecting the
capacity of the Australian banking sector to absorb credit losses, are recovered from the ASRF model
and compared with nancial statistics and external credit ratings. With the implementation of Basel II
preceding the time when the effect of the nancial crisis of 2007-2009 was most acutely felt, the authors
measure the impact of the crisis on the Australian banking sector.
Findings Measurements from the ASRF model nd general agreement with signals from
macroeconomic indicators, nancial statistics and external credit ratings. This leads to a favourable
assessment of the ASRF model for the purposes of capital allocation, performance attribution and risk
monitoring. The empirical analysis used in this paper reveals that the recent crisis imparted a mild
stress on the Australian banking sector.
Research limitations/implications Given the range of economic conditions, from mild
contraction to moderate expansion, experienced in Australia since the implementation of Basel II, the
authors cannot attest to the validity of the model specication of the IRB approach for its intended
purpose of solvency assessment.
Originality/value – Access to internal bank data collected by the prudential regulator distinguishes
this paper from other empirical studies on the IRB approach and nancial crisis of 2007-2009. The
authors are not the rst to attempt to measure the effects of the recent crisis, but they believe that they
are the rst to do so using regulatory data.
Keywords Financial crisis, Distance-to-default, Asymptotic single risk factor (ASRF) model,
Credit value-at-risk (VaR), Internal ratings-based (IRB) approach, Reverse stress testing
Paper type Research paper
1. Introduction
Under the Basel II Accord, authorised deposit-taking institutions (ADIs) determine
regulatory capital for credit risk using either the standardised approach or, subject to
approval, the internal ratings-based (IRB) approach. The latter is more expensive to
administer but usually produces lower regulatory capital requirements than the former.
As a consequence, ADIs using the IRB approach may deploy their capital in pursuit of
The current issue and full text archive of this journal is available on Emerald Insight at:
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JFRC
24,2
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Journalof Financial Regulation
andCompliance
Vol.24 No. 2, 2016
pp.106-139
©Emerald Group Publishing Limited
1358-1988
DOI 10.1108/JFRC-05-2015-0024
more (protable) lending opportunities. This paper examines the model specication of
the IRB approach, the so-called asymptotic single risk factor (ASRF) model. We render
an assessment of the ASRF model by taking readings of the Australian banking sector
since the implementation of Basel II and comparing them with signals from
macroeconomic indicators, nancial statistics and external credit ratings. The relatively
short quarterly time series available leads to an intuitive assessment of the ASRF model
rather than any formal testing of its efcacy. A fundamental evaluation of the model
specication of the IRB approach requires access to internal bank data, which are input
to the ASRF model. Support for this research by the Australian Prudential Regulation
Authority (APRA) includes access to these data collected by APRA from the institutions
that it supervises.
Upon implementation of Basel II in the rst quarter of 2008, APRA had granted
the four largest Australian banks, designated “major” banks, approval to use the
IRB approach to capital adequacy for credit risk. To take measurements from the
ASRF model of the Australian banking sector, we aggregate data reported to APRA
by the major banks on a quarterly basis since the implementation of Basel II. We
contend that these data are representative of the Australian banking sector on the
basis of the market dominance of the major banks and the concentration of their
regulatory capital assessed under the IRB approach. The ASRF model calculates the
expectation of credit losses conditional on a realisation of the single systematic risk
factor, which is interpreted as describing the state of the economy, to assess
regulatory capital charges. Substituting credit losses incurred into the ASRF model,
we solve for realisations of the single systematic risk factor describing the
prevailing state of the Australian economy. Then, substituting provisions and
capital held against credit losses into the ASRF model and translating realisations
of the single systematic risk factor into distance-to-default, we measure the level of
capitalisation of the Australian banking sector. Our empirical ndings comport
with signals from macroeconomic indicators, nancial statistics and external credit
ratings. While making observations about the prevailing state of Australia’s
economy and the solvency of its banking sector, we neither propose model
enhancements nor draw policy implications, although our observations may open a
debate on the model specication of the IRB approach or related regulatory policies.
The range of economic conditions, from mild contraction to moderate expansion,
experienced in Australia since the rst quarter of 2008 translate into observations
away from the tail of the distribution of the single systematic risk factor and, hence,
the portfolio loss distribution. Accordingly, we argue that our ndings support a
favourable assessment of the ASRF model for the purposes of capital allocation,
performance attribution and risk monitoring – management functions that need
only be accurate in the measurement of relative risk under “normal” economic
conditions. The IRB approach, however, serves the sole purpose of solvency
assessment, which requires precision in the measurement of absolute risk levels
under stressed economic conditions or tail events (Basel Committee on Banking
Supervision, 2010). Therefore, we cannot attest to the suitability of the ASRF model
for regulatory capital modelling. Evaluating the model specication of the IRB
approach for its intended purpose of solvency assessment would involve taking
readings of banking jurisdictions that have experienced a full-blown economic or
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Basel II
internal
ratings-based
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nancial crisis since the implementation of Basel II. It would supplement the
ndings of this study.
The nancial crisis of 2007-2009, also known as the global nancial crisis,
precipitated the worst global recession since the Great Depression of the 1930s. In
response to the crisis, the so-called Basel 2.5 package and Basel III Accord introduce
reforms to address deciencies in the Basel II framework exposed by the recent
crisis. The Basel 2.5 reforms enhance minimum capital requirements, risk
management practices and public disclosures in relation to risks arising from
trading activities, securitisation and exposure to off-balance sheet vehicles. The
Basel III reforms raise the quality and minimum required level of capital; promote
the build up of capital buffers; establish a back-up minimum leverage ratio; improve
liquidity and stabilise funding; and assess a regulatory capital surcharge on
systemically important nancial institutions. These reforms complement, rather
than supersede, Basel II. In particular, the ASRF model prescribed under the Basel
II IRB approach is unaltered by the introduction of Basel 2.5 and Basel III. It remains
as relevant to solvency assessment today as it has been since its implementation in
2008.
From our fundamental assessment of the model specication of the IRB approach
emerges a methodology for regulators to monitor the prevailing state of the economy as
described by the single systematic risk factor, and the capacity of supervised banks to
absorb credit losses as measured by distance-to-default. Measurements from the ASRF
model signalling an overheating economy and procyclical movements in capital bases,
corroborated by macroeconomic performance indicators including rapidly accelerating
credit growth, would prompt supervisors to lean against the prevailing winds by, for
example, instructing banks to build up their countercyclical capital buffer introduced
under Basel III.
The effects of the nancial crisis of 2007-2009 were not felt evenly across the globe,
and the Australian economy was largely spared. With the implementation of Basel II
preceding the time when the effect of the crisis was most acutely felt, our empirical
analysis reveals that the crisis imparted a mild stress on the Australian banking sector.
We are not the rst to attempt to measure the effects of the recent crisis, but we believe
that we are the rst to do so using regulatory data. In evaluating the model specication
of the IRB approach, we produce a fundamental assessment of the impact of the crisis on
the Australian banking sector using internal bank data collected by APRA. Other
studies on the nancial crisis rely on market data, macroeconomic indicators or
published nancial statistics. In arguing the resilience of the Australian economy to the
crisis, McDonald and Morling (2011) and Brown and Davis (2010) describe its
performance primarily in terms of macroeconomic indicators and nancial statistics.
Our measurements from the ASRF model of the Australian banking sector corroborate
their observations. Allen and Powell (2012), on the other hand, rely on market data and
reach a markedly different conclusion about the condition of the Australian banking
sector during the recent crisis. We submit that their results are biased by plummeting
market prices and spiking volatility reecting the overreaction of market participants
gripped by fear at the depths of the crisis.
We begin in Section 2 by outlining the model specication of the IRB approach and
discussing valid criticisms levelled against it. In Section 3, we describe the Basel II capital
adequacy reporting of ADIs that supplies data for our empirical analysis. Section 4
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