Basel II: The role of credit bureaus

Farayi Dyirakumunda
To enable the global banking sector to function efficiently, a set of international banking agreements called the Basel Accords were developed by an international committee on banking supervision. The accords are an important part of the global financial system as they were created to strengthen financial markets and guard against financial shocks which may occur when a faltering banking sector hurts the operations and outlook of the real economy.

The negative effects of a banking crisis are not alien to Zimbabwe and at a recent meeting with experts from the South Africa-based Centre for Financial Regulation and Inclusion (CENFRI).

“I was asked if our credit reference bureau is geared to service banks in their efforts towards Basel II compliance and the strengthening of the local banking sector”.

After deliberating our expertise in credit risk management with the CENFRI team.

This series of articles will firstly look at the intent of the Basel Accords and elaborate how the Zimbabwean banking sector will benefit from the value offered by private credit reference bureaus such as XDS in their compliance with Basel II.

In simple terms, the Basel Accords serve to determine how much capital a bank must hold based on a detailed and precise knowledge of the risks incurred by the banks.

The decision to hold this capital and to subject owners to a potential loss in case of failure is one of the measures that signals to depositors and potential investors that the bank will not undertake too much risk.

Furthermore, it is also important that banks be adequately capitalised for several other reasons aside from the fact that the RBZ mandates it:

l Holding adequate capital encourages banks to undertake better managed risk since their capital is at risk in case of failure.

l The capital provides a buffer against certain cash flow shortages, which can pay depositors if the need were to arise.

l Banks know more about the soundness of their operations than investors (what economists call information asymmetry) and if a bank is forced to close, capital can be used to pay off unpaid debts.

Basel II therefore serves to adequately align the required regulatory capital with actual bank risk.

The accord has multiple approaches for different types of risk and operates on three pillars namely, Minimum Capital, Supervisor Review and Market Discipline.

The accord recognises three main risk categories: i. Credit Risk, ii. Market Risk iii. Operational Risk and ultimately a bank must hold capital against these three types of risks.

The role of credit reference bureaus is in the first risk category of Credit Risk.

We enable banks to objectively and accurately assess the quality of its credit assets and thereby evaluate and analyse the concentration of its risk exposures.

This may be sectoral, geographical or by customer among other criteria.

In addition, the bureau will have served to encourage responsible credit behaviour by enforcing discipline on borrowers.

We have seen this in action within multiple sectors that utilise our credit exposure reports in their credit granting process and it helps limit consume over-indebtedness because a borrower’s credit standing which is dependent on the individual’s capacity to meet their financial obligations, becomes known to all institutions.

In addition, bureaus are also an instrument to give a better understanding of the corporate clients including Small to Medium Enterprises (“SME”) and their credit standing as they turn to the banking sector in search of financing to carry out their investment projects.

It is therefore clear that private credit reference bureaus are critical in providing a better and more accurate picture of borrowers in addition to facilitating appropriate analysis of their creditworthiness. We foster greater transparency and encourage healthy competition between credit providers including banks as interest rates and the cost of credit will be in line with the actual risks incurred.

In other words, we allow easier access to the credit market on better terms.

From the macro-prudential standpoint, this contributes to raising the stability of the financial system as a whole and encourages analysis and research geared to arriving at an accurate assessment of the inherent credit risk of the banking system.

Basel II allows for credit granting institutions to use their own credit risk models (specifically, their estimates of Probability of Default (“PD”), Loss Given Default (“LGD”) and Exposure at Default (“EAD”) to determine their minimum regulatory capital, provided they are adequately validated.

A credit bureau therefore has an important role to be used as the basis on which to develop an overall rating system and thus act as a supplementary tool in verifying the Probability of Default.

Our system capabilities and expertise enable XDS to maintain and process the most precise information possible so that the minimum regulatory capital, among other parameters, can be determined accurately.

Regarding LGD, the bureau comes into play with a solution based on the practical application of the information contained in our systems.

Under this approach, supervisors could obtain individual values of LGD based purely on credit data, with which the banks’ estimates could ultimately be compared.

Validation would be carried out via an empirical estimate of the LGD itself based on quantitative variables in order to identify which of them turn out to be statistically significant determinants of the LGD.

Regarding EAD validation, we simply compile the main characteristics of loan commitments and can thus provide information on drawn and undrawn exposures.

An analysis of how borrowers make use of their credit commitments over time would be a good first approximation for validating EAD.

Moreover, as noted above for LGD, an assessment based on qualitative elements could also be a reasonable validation solution.

Our potential to contribute notably to this crucial task of implementing Basel II has thus been established.

Given our capabilities, the financial sector and supervisors have a unique opportunity, at a relatively low cost, to adapt, adjust and, finally, take full advantage of these instruments so that they may contribute to Basel II in a rigorous and orderly manner.

 Farayi Dyirakumunda is a director at XDS Zimbabwe, a credit reference bureau and risk management company. He can be contacted on [email protected] / www.xds.co.zw

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