The Basel Committee’s capital
guidelines have recently received quite heavy criticism. David
Molyneaux, principal consultant at FICO and formerly head of Basel
Development-Retail Credit for the RBS Group, explains how Basel III
could help the financial industry emerge stronger from the
The key tenets of
Basel III are an improvement in the quality of capital held by
banks and an emphasis on counter-cyclical capital management. The
former has been the topic of debate, but the real key to the
success of the system likes in the new emphasis on engraining
counter-cyclicality into the financial system via the
counter-cyclical buffer (CCB).
Put simply, counter-cyclicality
refers to building stabilisers into the banking sector to
counter-balance the influence of the wider economy. One of the main
weaknesses of Basel II was that by reducing risk-weightings on
asset-backed securities, it exacerbated cyclicality in economies
and helped sow the seeds of the financial crisis. The phasing-in of
a CCB requirement is intended to prevent the build up of excess
credit growth and ward off future crises.
While the CCB is an important first
step, it is necessary for change to occur systematically within
risk measurement practices in order to address pro-cyclicality. At
the bank level, it is critical to rethink the tools financial
institutions are using to make risk and capital management
For example, credit scoring models
currently give a ‘point-in-time’ assessment of risk which feeds in
to a customer’s probability of default (PD) for loans. If the
economy is improving, credit scores tend to improve because people
have fewer delinquencies.
The odds-to-score relationship –
the ratio of future ‘good’ to future ‘bad’ accounts – will also be
higher, which means that the PD reduces, and by extension, the risk
weights and the amount of capital required to be held also
decrease. This can cause over-extension of credit in favourable
The converse is also true; with
more delinquencies, scores go down, the odds-to-score relationship
deteriorates, pushing PD up, and the risk weights and amount of
capital required increase. This can lead to an over-tightening of
credit policy during downturns.
This point-in-time approach is
pro-cyclical, and affects not only the overall credit picture but
also a bank’s own risk levels.
For instance, if a bank sets its
cut-off for credit issuance to 600 and maintains it for 18 months,
although the score should be changed to 630 to maintain the same
odds-to-score level, that bank has had 18 months of
higher-than-anticipated losses in its portfolio.
Banks need to combine the
point-in-time approach of scoring with forward-looking economic
modelling. This will help them understand the influence the economy
plays in changing both customer scores (score migration) and
score-level default rates (odds-to-score relationships).
This approach is demonstrated at
FICO by providing forward-looking odds-to-score estimates based on
differing economic scenarios.
These analytics leverage estimates
of future economic indicators – eg unemployment, GDP, interest
rates – to see how they would affect PDs among borrowers at
different score levels. Furthermore, the macroeconomic variables
can be set at values that represent how the economy will look once
it is through the turning point in its cycle.
By using these kinds of economic
modelling tools married to risk scores, banks can meet Basel III
requirements while protecting their portfolio from swings in the
Ultimately, the Basel III counter-cyclical measures are intended
to make the banking system safer, more efficient and potentially