Financial and
Regulatory Reporting

Executive Summary

When people deposit their money, banks have sufficient deposits/capital to provide credit financing to borrowers. For the described system to keep working, regulators have come up with rules that have two main goals:

1. Regulating bank operations and hereby reducing risky behavior.
2. Guaranteeing to the public that the banking system is in good health.

Specifically, this means that regulators require the banks to hold a certain amount of capital. This capital would allow the banks to absorb losses from loan defaults. These loan defaults can either be caused by personal or global economic factors. For instance, a company can default on a loan from bad management, a decrease in its product demand or rather global financial crisis. Therefore, banks are required to hold sufficient capital that would allow them to absorb the loss. This obligation is called the capital requirement.

IFRS 9 and CECL

Lifetime expected loss modelling is important for IFRS 9 loan loss provisioning, as it conditions credit risk predictions on the current economic state. Larger banks mainly outside the US are subject to IFRS. IFRS 9 is based on Current Expected Credit Loss (CECL) which requires computation of lifetime expected loss (LEL) as a basis for loan loss provisioning. CECL is based on a point-in-time (PIT) approach, the current economic conditions, and the risk over the lifetime of financial instruments.

Capital Requirement: Capital Adequacy Ratio

The capital that a bank needs to have on its balance sheet is determined by the proportion of its assets (mainly loans). The risk associated with each loan or portfolio is taken into account to determine the bank’s capital requirement. This process results in risk-weighted assets. The capital requirement suggests that banks must hold capital equal to or above a certain percentage of the risk-weighted assets. The ratio between a bank’s capital and risk-weighted assets should be equal to or greater than a certain percentage. This ratio is referred to as the Capital Adequacy Ratio (CAR).

Capital Adequacy Ratio (CAR)

Basel II Accord

Basel II Accord is one of the essential documents that specify: 1. How much capital banks need to have 2. How capital is defined 3. How capital is compared against risk-weighted assets. Its primary objective is that a bank’s capital allocation is risk sensitive. Put simply, the greater the risk a bank is exposed to, the greater the amount of capital it should possess to protect its solvency and overall economic stability.

The Three Pillars of Basel II

1. Minimum Capital Requirements
2. Supervisory Review
3. Market Discipline

Basel II Accord – Approaches

It prescribes that banks should choose from two different approaches when assessing credit risk, specifically when they calculate each of the two components of the Expected Loss, namely PD, LGD and EAD. The two approaches are:

1. 1.Standardized Approach (SA)
2. 2.Internal Ratings Based (IRB) Approaches
3. 2.1. Foundation Internal Ratings Based (F-IRB) Approach
4. 2.2. Advanced Internal Ratings Based (A-IRB) Approach

Capital requirement is calculated differently under the two approaches.

Standardized Approach (SA)

The capital that has to be held is specified as the percentage of the total exposure. The data used to assess credit risk should be provided by external credit agencies (e.g. FICO, S&P Global, Moody’s, Fitch Ratings). Examples of calculating capital requirements under SA: A bank lending to corporations will have to charge a country credit premium to its corporations in addition to their credit risk premium to account for the specific region’s country risk.

Interpretation: 20% of the exposure amount should be held as capital against countries rated between A+ and A-

A bank lending to individuals will have to charge a country credit premium to its customers in addition to their individual credit risk premium to account for the specific region’s credit risk.

A bank lending to a retail customer:

1. An amount proportional to the 75% of the exposure should be held as capital for every retail loan such as credit cards and consumer loans.
2. An amount proportional to the 35% of the exposure should be held as capital for loans secured by residential properties such as mortgages.
3. Also, the equivalent of a greater proportion of the exposure of some overdue loans may be held as capital.

External credit ratings are reliable and reflect the creditworthiness of entities well, but SA doesn’t allow much flexibility for the banks. Banks are collecting a lot of data in the process of allowing a detailed estimation of credit risk, which would result in a more precise calculation of the amount of capital banks should possess against each exposure. This is why Basel 2 Accord allows banks to use IRB approaches to calculate credit risk.

Internal Ratings Based (IRB) Approach

The capital that has to be held should be sufficient to cover Expected Loss (EL), which is calculated as PD * LGD * EAD. It allows banks to establish their own credit ratings.

F-IRB vs A-IRB

They differ in components that banks can estimate themselves.

1. Under F-IRB: PD internally estimated and LGD and EAD externally provided.
2. Under A-IRB: all 3 components can be internally estimated.

Banks usually start with SA and then transition to the IRB approach. The more precisely the estimate of their capital requirements, the less capital needs to be hold. Therefore, more free capital will be at their disposal for doing new business. For example, under SA the RWA = 75%, therefore, banks should hold 8% of 75% from each loan. However, under the IRB approach the RWA would surely be lower than 75%.

Estimation details for PDs, LGDs, and EADs between Basel and IFRS may differ. For example, Basel is based on a 12-month expected loss and through-the-cycle concept. Basel includes no macroeconomic variables, hence it’s less affected by economic circumstances. On the other hand, IFRS 9 calculates PDs, LGDs, and EADs based on current economic circumstances and takes future predictions into consideration.