Understanding the Basel II Use Test in a Changing Credit Cycle: The Basel II "Use Test" Requires Significant Resources to Implement, but It Promises to Usher in an Exciting New Era for Banking

Article excerpt

Tucked away amid the 800-odd paragraphs of the Basel Committee on Banking Supervision's International Convergence of Capital Measurement and Capital Standards: A Revised Framework, otherwise known as the Basel II Framework, are two paragraphs relating to a "use test" directive.

Under the "Use of Internal Ratings" heading, paragraphs 444-45 describe the degree to which financial institutions must incorporate Pillar 1 model estimates and the composite elements of expected loss, risk-weighted assets, and regulatory capital into everyday banking practices for three years prior to obtaining regulatory approval. A memo issued by the Basel Committee in September 2006 enhances the use test by broadening its operational, governance, and fiduciary impacts. This treatise lays down principles giving retail credit bankers freedom to execute strategies in line with their market approach and to maximize bottom lines by optimizing the risk-reward relationship.

Traditionally, retail-credit-granting institutions have given less attention to integrating sophisticated decision-making tools into everyday banking processes throughout the credit cycle. Retail banks successfully implementing the use test have demonstrated core competencies for models and governance throughout the origination, management, and disposal of retail credit assets. These competencies include validation and stress testing, capital adequacy reporting, expected and unexpected loss measures, and audit and disclosure controls. Pillar 1, 2, and 3 rigors within credit, market, and operational risk must be integrated into bank credit practices. In addition, the endorsement of senior management, executives, the board, and regulators must be obtained. Basel II elicits banks to tie provisions and capital to their own risk tolerance. Retail banks also must achieve project investment return while employing Basel II model estimates.

Minimum Requirements for Use Tests

Incorporating the use-test precepts is daunting while maintaining established capital hurdle rates, portfolio credit quality standards, overall profitability, and development of new products and services leading to shareholder content and corporate profitability. Banks aspiring to Basel II advanced internal-ratings based (AIRB) compliance must reach these milestones. The challenge lies in balancing the opinions of senior management, executives, the board, audit, and the regulatory bodies in a cohesive, sustainable fashion. The use test identifies elemental requirements that enable banks to make the leap between theory and practice. The seven components of the use test follow.

Time and Consistency

Time and consistency are functional considerations of the Basel II model estimates. Model calibration should include three years of data prior to qualification. Regulators may favor longer model data collection periods (five to seven years), but shorter periods may be acceptable given a higher emphasis on model validation and stress testing. Regulator concerns for model predictability focused on the most recent two years are natural, particularly when determining capital adequacy levels, given the credit market turmoil surrounding U.S. mortgage lending in 2007-08. Rigorous model-development processes demonstrating adherence to regulator-sanctioned model-development techniques and careful collection, pruning, and final selection of predictive variables are essential. This includes recalibration or redevelopment of models; stress testing for downturn and long-run average estimate allowances; and out-of-time, out-of-sample, and even out-of-industry validation.

Model Usage

The use test calls for rating systems to be present throughout internal risk management in addition to capital adequacy calculations. Models must espouse borrower and transactional dimensions--that is, a two-dimensional risk-rating system. Risk management units must prove model accuracy across ranges of borrowers and facilities to which they are exposed. …