Dear:
As we discussed in previous posts, we are in the midst of a systemic transformation: from a volume-based financial system to one based on efficient capital management.
In a globalized financial system, efficient capital management requires a commonly accepted regulatory framework for measuring the capital consumed by a bank's assets.
The main sources of current banking regulation are the International Accounting Standards Board (IFRS) and the Basel Committee on Banking Supervision (Basel IV).
http://www.ifrs.org/About-us/IASB/Pages/Home.aspx
https://www.bis.org/bcbs/
The BCBS's primary responsibility is to establish capital requirements to ensure the financial stability of the banking system, while the IASB's primary responsibility is to establish fair valuations of assets.
In reality, both organizations address the same problem: the measurement of capital consumption, from different perspectives.
- IFRS. The Fair Valuation of a Financial Asset determines the provisions that adjust the Nominal Value of the Asset to a Fair Value, which includes the Cost of Risk.
- Basel IV. The capital requirements of an asset determine the capital consumed when investing (or lending).
It seems reasonable to establish some level of reconciliation between the two approaches.
Basel IV requires banks to accumulate capital during the expansion phase of the business cycle to cover possible losses during the contraction phase. These countercyclical capital requirements are not tied to any particular loan, so they are generic.
On the other hand, International Financial Reporting Standards establish the provisions that banks must recognize to cover losses in their portfolio due to events that have already occurred and will affect future cash flows.
Some of these losses come from detected bad loans, but others come from bad loans that we know exist in the portfolio, but that we have not yet detected. Therefore, we must evaluate the entire portfolio and adjust its value globally, also through a Generic Provision.
But the problem remains: how to determine the Fair Provision for a hidden bad loan?
An interesting approach to determining the value of these generic provisions uses the Internal Ratings-Based Approach to Credit Risk Calculation (Basel IV).
To calculate IRB Credit Risk, we must evaluate several components: Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD), and contract maturity (M).
In addition, the IRB method allows us to calculate the expected portfolio loss (PE), which corresponds to the expected loss of each loan, calculated with the following formula:
PE=PD*LGD*EAD
For our reconciliation exercise, we use the IRB method's Expected Loss concept, which is similar to the IFRS concept of Incurred Losses, but not exactly the same.
IRB Expected Losses are the average loss stream that internal rating calculation methods predict will materialize in a year, while IFRS Incurred Losses are the balance of losses existing in the portfolio at a given time, due to past events that will generate losses in the future.
Both Incurred Losses and Expected Losses are different from the annual manifest losses (annual default stream) and, consequently, from the annual stream of specific provisions.
However, we can calculate Incurred Losses under IFRS by estimating the annual stream of expected losses and the time elapsed from the event that causes the loan to default until the moment it becomes apparent. This period between the two events is called the Loss Identification Period (LIP).
For example, if the counterparty loses their job and becomes unable to meet their payment obligations 18 months later, the Loss Identification Period would be 18 months.
Therefore, if we know both quantities (the Expected Losses and the Loss Identification Period), we can estimate the Incurred Losses by multiplying them.
For example, if the calculated Expected Losses for our portfolio (IRB method) are $45 million per year and the average Loss Identification Period is 2 years, this means that the Incurred Loss in our portfolio is $90 million.
Incurred Losses (IFRS) = Expected Losses (IRB Method) * Loss Identification Period
During the upswing of the business cycle, the Loss Identification Period is longer due to easier refinancing policies and favorable economic conditions.
According to the formula, a longer Loss Identification Period will increase Incurred Losses during the upswing.
In this way, we reconcile the calculation of IFRS Generic Provisions with the countercyclical capital buffer required by Basel IV.
The Integrated Financial and Risk Architecture holistically assesses capital consumption for Credit Risk, both from a solvency perspective (Basel IV) and from an accounting perspective (IFRS-9).
In Bank Analyzer Credit Risk, we determine the Probability of Default, the Loss Given Default, and, of course, the Expected Loss for each exposure, dynamically applying collateral and guarantees.
Secondly, SAP Financials Product Subledger uses the results of the Basel IV Credit Risk calculation as input for the calculation of IFRS-9 provisions.
Applying the above method to a real bank's portfolio management requires an integrated accounting (IFRS) and risk management (Basel IV) system within a holistic data model. This is the foundation of Bank Analyzer's Integrated Financial and Risk Architecture and makes it the best system for measuring a bank's available and consumed capital.
The results of the Basel IV and IFRS-9 calculations are holistic and reconcilable for the common dimensions of the Result Data Area of the Integrated Financial and Risk Architecture. This is why this architecture offers us a reconcilable and holistic view of capital consumption for Credit Risk.
The capital consumption for Market Risk is still missing, as it is only available in the Results DataBase. This lack of integration can be partially resolved with the open architecture of the Integrated Financial and Risk Architecture, but this would be the subject of another article.
The next level is Capital Optimization, which requires the integration of Real Economy and Financial Economics processes. For the past 12 years, our team has worked on modeling all economic events and business flows represented in Real Economy SAP systems, in terms of capital and liquidity consumption and generation. With this information, our systems measure how to offer financial instruments to cover capital and liquidity gaps or invest excess capital and liquidity, thus optimizing the system's capital consumption and liquidity.
We are working to introduce our system to the market and are looking for business partners and investors. If you are interested, please do not hesitate to contact me.
ferran.frances@gmail.com
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Looking forward to reading your opinions.
Kindest Regards,
Ferran Frances.
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