Mr Desario discusses new approaches to the
international regulation of credit risk
Address by Dott. Vincenzo Desario, Director General of the Bank of Italy at the 5th ABI Convention
on the Development and Management of Loan Portfolios held in Cernobbio on 15 October 1999.
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Introduction
My thanks, first of all, to the Italian Banking Association for the invitation to give the opening address
at this conference on new methods for developing and managing loan portfolios.
The subject is highly topical. Today, as interest rates converge on the lowest levels since the Second
World War, banks' competitiveness depends more than ever on their ability to select customers and
offer the most appropriate forms of credit, so as to curb credit risk and generate yields above the cost
of funds.
Analysis of the crises that have shaken many credit systems in recent years confirms that the main
source of bank instability lies in their lending business; cyclical swings in the economy, sharp changes
in asset values, high credit concentration, and inadequate procedures for evaluating and managing
loans have been the main factors in most bank failures.
Inquiry into the causes of instability has been followed by action to reinforce safeguards against crises,
strengthen banks' credit risk management systems, make market discipline more effective, and
improve supervisory authorities' prudential rules and analytical methods.
The Italian banking system's bad debts rose rapidly in the nineties, although in the last two years loan
quality has Improved thanks to companies 1 better profit performance and financial restructuring.
Innovative market techniques for credit risk management have recently been introduced and some
banks have begun to use advanced statistical methods of risk measurement.
1. Bank credit and the market
In 1999 the ratio of new bad debts to total lending has fallen to its lowest level in the decade. The
improvement, which had already been perceptible for some time in industrial lending, has spread to
construction and services.
In August the stock of bad loans held by banks was 5 per cent lower than a year earlier. The reduction
was achieved by means of substantial writeoffs and the disposal of uncollectible claims through
securitization.
Selling credit assets to the market allows banks to turn their portfolios over faster and broaden their
borrower base, thereby using capital more efficiently and diversifying their sources of income to
include fees for the services related to the complex procedures of securitization.
In the United States the volume of credit securitization business has grown enormously. In 1998 net
issues of such securities amounted to more than $300 billion, or 35 per cent of total issues of debt
instruments. Their share of outstanding debt is now more than 20 per cent.
In the US market, securitization has centred on loan assets of better-than-average quality, which has
led to the issue of highly rated securities. In Italy, it has been used mainly to reduce the incidence of
doubtful credits and thus improve the average quality of banks' assets. Since 1994 some 8 trillion lire
of bank loans have been securitized, of which only 400 billion consisted of performing loans.
The passage in April of a law on securitization opens up business possibilities previously foreclosed
by uncertainty about the legal framework. The prospects for growth depend strictly on banks' ability
and willingness to offer the market good quality claims and to develop the entire gamut of services
and specializations required. Bank managements will have to acquire the specific know-how needed
for the evaluation of the complex risk-return combinations involved.
There is also growing recourse by some leading Italian banks to credit derivatives, which allow credit
risk to be transferred while maintaining title to the underlying credit relationship.
The possibility of isolating one or more aspects of the risk associated with credit business and
transferring them to other parties via derivative contracts enables banks to keep only the components
of risk that they consider they are best equipped to handle. This trend towards specialization explains
the high degree of concentration in credit derivatives business. In June 1999 the top five US banks
accounted for 80 per cent of the American market with positions totaling $258 billion.
Italian banks' credit derivatives business is mostly channeled through their foreign branches; not only
does it respond to the need to diversify risk but it also allows them to penetrate new markets by
acquiring positions with customers that it would otherwise have been difficult to establish business
relations with. At the end of the second quarter of 1999 the notional value of Italian banks' contracts
in the United States amounted to $15.3 billion, or 6 per cent of the total market.
The development of credit derivatives in the Italian market is likely to make it easier to implement
policies aimed at correcting situations of excessively concentrated sectoral and geographical lending.
2. The experience with solvency ratios
The capital adequacy rules introduced by the Basel Capital Accord of 1988 constitute the main point
of reference for supervisory authorities everywhere. The basic elements of the Accord are still fully
valid today: capital resources as the safeguard of banks' stability, risk-weighted capital ratios, capital
requirements for off-balance-sheet assets. Since the publication of the Core Principles of the Basel
Committee on Banking Supervision, to which supervisory authorities everywhere were asked to
adhere, at least 140 countries have adopted the Committee's approach in their regulation of banking.
The Capital Accord was intended to raise banks' level of capitalization, following decades of decline
in the main banking systems. It also aimed to enhance the entrepreneurial initiative of bankers within a
framework of close correlation between risks and capital resources and, through common prudential
rules, to promote conditions of competitive equality among internationally active banks.
Drawing a balance sheet today, the results have been very largely positive.
The degree of capitalization has risen almost everywhere, making banking systems more resilient. The
average solvency ratio of international banks located in the G10 countries rose from 9.3 per cent in
1989 to 11.6 per cent in 1998.
Over the same decade the average solvency ratio for individual banks in Italy rose from 11.7 to 13.4
per cent.
The improvement in capital adequacy has been fostered by the forceful action of the supervisory
authorities, which has led banks to expand their capital resources in parallel with the rapid growth in
higher-risk assets.
Uniform capital requirements have also attenuated competitive handicaps stemming from disparities in
the strictness of national banking regulations. They do not appear to have resulted in significant
changes in the competitive position of banks compared with other, less strictly regulated financial
intermediaries. In some countries, including Italy, many non-bank intermediaries have been
transformed into banks.
Studies on the impact of capital ratios, conducted mainly in the United States, have found temporary
slowdowns in some markets but not contractions in the supply of credit affecting the aggregate level of
economic activity.
Ten years of rapid financial innovation and progress in developing statistical methods for measuring
banking risk have highlighted some of the limitations inherent in the specification of the capital
requirements. The rigidity of the standards has not encouraged the adoption of techniques to reduce
credit risk; it has induced practices for circumventing the rules.
The current definition of the capital requirements cannot capture the variation in credit risk stemming
from cyclical developments; nor does it take account of the correlation between the risks associated
with various assets and hence of the benefits implicit in well diversified portfolios.
The benefit accorded to financial techniques of risk-shifting, in terms of reduced capital ratios, is
insufficient, while banks are increasingly taking measures to lessen capital requirements that do not
actually diminish risk.
The limited diversification of the risk weights applicable to assets makes it possible for banks to select
higher risk-return combinations.
3. The evolution of prudential rules on credit risk
The Basel Committee has focused on the need to strengthen the set of legal rules safeguarding bank
stability by defining capital adequacy requirements in greater detail, improving the structures and
methods for the management of credit risk, reinforcing the discipline exerted on banking enterprises
by the financial markets.
In June the Committee released a set of proposed revisions of the capital adequacy rules, asking for the
comments of the banking industry with a view to their definitive formulation in the second half of next
year. During the summer it distributed documents setting out best practices in credit risk management,
disclosure requirements and supervisory activity.
For the time the idea of determining the capital needed to face credit risk by means of internal models
devised by banks themselves has been shelved, pending resolution of the problems with existing
methods and in view of the costs associated with producing such models. For the future, such models
represent an opportunity to be pursued, in view of the possibility they offer of measuring credit risk
more exactly and more analytically and of factoring in the correlation between different risks. They
generate estimates that gauge the capital needed to cover the largest loss that could occur in any given
period of time and with any given probability.
For lending to firms, the Committee's proposed changes provide for two distinct methods of
determining risk weights: the ratings of specialized agencies, which are only available for a limited
number of borrowers, and internal ratings, which the banks can assign to all their customers.
For the standard method, the Committee has established the requirements that agencies must meet for
their ratings to be used in determining capital ratios for banks. The requirements refer to agencies'
credibility and independence as well as to the objectivity and transparency of their judgments.
The criteria for supervisory authorities' validation of internal rating systems have not yet been fixed.
They will certainly include the completeness of the data, the methodological rigour of the procedures
and provision for verification of the results.
There remains the complicated problem of defining a common yardstick to which to relate the results
of the various banks' internal rating systems, in order to make sure that capital requirements are
uniform. Another problem to be faced concerns the comparability of the criteria for weighting the risk
on loans to companies with agency ratings and those with internal ratings.
4. Credit risk management and banks' internal organization
The adoption of internal ratings as the basis for calculating risk coefficients creates a direct link
between the regulation of capital requirements and banks' internal structures for formulating lending
policies and for assessing, pricing and monitoring the risks involved in individual operations.
The Basel Committee has established the guidelines banks are to follow when making arrangements
for credit risk management.
Banks' directors play a fundamental role in ensuring both that lending policies are consistent with
banks' ability to handle credit risks and that periodic cheeks are carried out on the results achieved.
Clear information on policy choices must be given to all bank structures involved in lending.
To ensure that objectives are attained, banks' top managers must ensure that precise instructions are
circulated setting out the various levels of responsibility, establish operational limits and extend credit
risk management systems to the whole range of bank assets.
When granting loans, banks should evaluate all the information available in order to acquire a
complete profile of borrowers, including their exposure to cyclical or sectoral events, group
relationships, if any, the use to which loans are to be put and the sources of the funds that will permit
repayment.
The monitoring of loans should be assigned to qualified personnel working independently of the units
responsible for granting credit.
Internal rating systems call for close liaison with the crucial aspects of risk management, such as
pricing, provisioning and deciding to review loans or ask for their repayment.
Exhaustive and continually updated information on borrowers' financial positions and on the value of
collateral is fundamental.
The flow of information provided to financial markets is essential to ensure that the discipline they can
impose on banks' managements is effective. The guidelines established by the Basel Committee for
periodic reports to the market cover all aspects of credit risk management: accounting practices,
provisioning policies, organization, customer assessment procedures, breakdown of the loan portfolio
by class of borrower, doubtful debts, collateral, volumes of derivatives and securitized loans,
commitments, expected and actual rates of return on loans.
The measures to address credit risk are completed by the activities of supervisory authorities directed
at ensuring the adequacy of each bank's capital resources in relation to its risk profile and corporate
strategies. It is up to supervisory authorities to evaluate whether banks' internal procedures can
perform the tasks of identifying, measuring and managing credit risk, to set higher capital ratios for
banks with particularly high risk profiles, to ensure compliance with capital requirements and to take
prompt action to prevent banks' capital from falling below acceptable levels.
The attention of the Bank of Italy has been directed towards banks' organizational arrangements for
some time; in 1988 banks were asked to complete a questionnaire on their internal structures, which
provided additional information on their organizations and served as a useful reminder to the banking
system of these issues.
The importance of banks' organizational arrangements is reflected in the regulatory framework.
Exactly one year ago the Bank of Italy's instructions to banks and banking groups introduced a
comprehensive set of provisions aimed at encouraging effective and efficient internal control systems
in proportion to each entity's size and operational complexity. Banks were also asked to report on the
systems they had adopted, their level of compliance with the new provisions, any critical factors
brought to light and the remedial measures required.
While respecting banks' entrepreneurial independence, general principles have been established that
are consistent with international guidelines; these include the separation between operational and
control functions, a clear definition of the responsibilities of banks' various units and special
regulations to ensure prompt corrective measures.
Particular attention has been dedicated to internal auditing, with a view to ensuring continuous cheeks
on the effectiveness of controls and the preparation of proposals to improve risk management policies,
instruments and procedures.
5. The thrust of current action
Briefly, an internal rating system embraces all the elements needed to measure the probability that a
borrower will become insolvent and the share of the loan that, in such case, will no longer be
recoverable; together, these two factors give the expected loss for each borrower.
While the probability of failure can be assessed in terms of the borrower's specific features such as
economic sector, financial structure and income prospects, the recovery rate for any credit line
depends on factors such as the technical form of the loan, the collateral and the lender's position in
relation to the borrower's other creditors.
Statistical methods of calculating these two components of expected losses require sufficiently long
time series on the frequencies of failures corresponding to each risk bucket and on the losses sustained
for the various categories of loans and collateral. The issue is made even more complicated by the fact
that both the probabilities of failure and recovery rates are affected by economic trends.
A survey carried out by the Basel Committee of about thirty leading international banks showed that
the problem is being addressed in ways that differ in many respects.
Internal assessment procedures evaluate the quality of either borrowers or credit lines, and in some
cases the two profiles are combined.
Evaluations may be based entirely on statistical models, or be supplemented with the opinions of
sectoral analysts and lending experts; in some cases limits are set on the scope for altering the results
of statistical calculations by adding qualitative considerations.
The various systems differ in terms of the variables used to approximate the probability of failure for
individual borrowers, the time horizons considered and the use of sectoral analyses. For many banks
the reliability of the procedures adopted is closely linked to their ability to capture promptly any
changes in a borrower's solvency position. Others, adopting a similar approach to that of rating
agencies, prefer so-called "across-the-cycle" evaluations, which consider the borrower's position in a
hypothetical unfavourable phase of the economic cycle.
A specific probability of failure can be assigned to each internal rating class either on the basis of the
bank's own experience or by using information published by rating agencies on the frequency of
failures.
Evaluations based on internal rating systems can be used by banks' directors and top management in
formulating lending strategies and setting limits to the autonomous granting of loans; they can also be
used in loan pricing procedures and to ensure the prompt reporting of any deterioration in borrowers'
positions.
The survey carried out in the G-10 countries included a number of Italian banks, mostly major ones,
and revealed some characteristic features of the approaches adopted in constructing a borrower
classification system.
The business sector is broken down by size; for small and medium-sized firms the first level of
screening for creditworthiness consists mainly of a statistical classification of borrowers based on data
culled from balance sheets and the Central Credit Register. The results of these automatic procedures
are generally modified, within set limits, by information concerning corporate management and
organization. In assessing larger firms the statistically-based elements carry less weight.
The recent start made on the systematic observation of the insolvency rates within each risk bucket
and the losses sustained in connection with secondary lending conditions means that the accuracy of
these procedures cannot be guaranteed, it is still too early to assess the ability of systems to capture
changes in the quality of credit linked to trends in economic activity.
Assessments of individual borrowers usually refer to a time horizon of one year, a practice that most
foreign banks also follow. The models in use are not able to take systematic account of the different
maturities of operations, while economic theory and experience both indicate that the maturity of loans
can have a marked impact on the related credit risks.
In their risk management procedures, Italian banks are increasingly resorting to models that measure
expected losses; they use the results in deciding whether to grant loans and in reviewing credit lines.
The distinction between the units that calculate ratings, those that are involved in marketing and those
that perform control functions appears to be well drawn. Nonetheless, the integration of the
customer-classification systems of the different components of banking groups is not entirely
satisfactory.
Medium-sized banks, of which one of the strengths has always been their specialized territorial
knowledge and entrenchment in the local economic tissue, are also making important changes in their
credit risk management procedures. By opening new branches and acquiring local banks, they have
rapidly extended their activities to be present on an inter-regional or national basis.
These banks have responded to the need for more effective and efficient loan selection procedures
mainly by reviewing their organizational arrangements, improving their information systems and
tightening their internal controls.
Specialized operational units have been created according to types of customer, with the granting of
large loans often being referred to "Committees" composed of particularly experienced head office
personnel; procedures for assessing creditworthiness have been improved through the use of
information technology to coordinate and accelerate the use of available information.
The enlargement of distribution networks has proved a strong incentive to decentralizing
decision-making for smaller loans.
To meet the requirements of control, special organizational units have been created to provide
centralized monitoring of loan positions; these maintain continuous contact with the central and
branch units engaged in granting loans, mostly through the use of computerized procedures that
identify possible anomalies in positions.
The most dynamic banks have supplemented these procedures with profitability indicators for
individual borrowers in order to improve their overall risk-return profiles.
Some of the more progressive medium-sized banks use internal rating procedures to support their loan
portfolio diversification policies and to establish consistent writedown and provisioning criteria.
Personnel training and specialization programmes need to be intensified in order to foster the spread
and acceptance of new methods.
6. Specialization profiles of Italian banks
With the spread of innovative techniques of credit risk mitigation, loan portfolios will tend to be
managed in more dynamic ways than traditionally, when the focus was on selecting borrowers and
maintaining positions until their natural maturity.
The forms of lending specialization that emerge clearly today in the Italian banking system are related
primarily to the type of borrower, defined in terms of size and product sector. There are important
changes under way in the composition of loan portfolios: one aspect common to the entire system is
the rapid growth in loans to households, while the pattern of lending to the corporate sector is
diversified.
In the nineties loans to households have grown at an average annual rate of around 11 per cent, or
about twice as fast as total lending, and they have risen from 13.8 to 18 per cent of total loans. With
interest rates declining and productive activity growing only modestly, banks have grasped the
opportunities offered by households' increased demand for credit; at the end of 1998 more than 95 per
cent of loans to households were held by the banking system, either directly or through subsidiary
financial companies.
Indicators such as shifts in the market shares of individual banks and the correlation with their interest
rates show that competition is intense and growing, partly owing to the entrance into the Italian market
of foreign intermediaries specialized in mortgage lending.
The expansion in the volume of business with households has been helped by the spread of technical
forms of lending whereby intermediaries rely to a great extent on credit scoring techniques to select
borrowers.
In the consumer credit field, which is characterized by a large number of small transactions, the need
to make decisions rapidly and minimize costs encourage the use of automated procedures. In the case
of loans for the purchase of consumer durable goods, the results of credit scoring models are
frequently decisive in deciding whether to lend; in that of personal loans, which are usually for larger
sums, branch personnel are allowed greater discretion; and, lastly, special agreements covering
specific groups of borrowers or particular categories of goods are often important.
In the case of mortgage loans, the assessment of the desirability of granting a loan hinges both on the
current and future ability of the borrower to pay and on the effective value of the collateral.
Improvements to the procedures for selecting and monitoring loans to households are possible and
necessary. The proportion of bad debts is high; the impact on banks' financial situations must be
evaluated in the light of the growing share of such lending in their portfolios. Last June - despite
frequent writeoffs of small positions, out-of-court settlements and disposals without recourse to
non-bank companies - 9.4 per cent of household loans were classified as bad debts, as against 8 per
cent for other loans.
As regards loans to enterprises, there has been a shift in their composition: in the eighties the share of
lending to small and medium-sized enterprises grew continuously throughout the banking system.
Since the early nineties the share of the economic sectors in which small companies predominate, i.e.
those for which the average loan was less than 500 million lire at the end of 1997, has fallen at banks
involved in mergers and acquisitions but has continued to increase for the rest of the system.
A similar pattern has already been analyzed in the US banking system, which has seen far-reaching
consolidation in recent years; it merits special attention in view of the importance of small firms in
Italy's industrial fabric. The recent consolidation of the Italian banking system does not allow a
definitive judgment to be passed on the process: the shift in the composition of loan portfolios could
be the result both of differences in lending policies and of the need to reorganize lending at banks that
are still being integrated; it undoubtedly reflects the need to reduce the riskiness of the loan portfolios
of banks with poor records that have been taken over.
The share of long-term credit to enterprises has not changed significantly. Repeated calls have been
made for enterprises to make more use of medium and long-term financing, which requires banks to
develop more detailed knowledge of borrowers, to make accurate assessments of their earnings
prospects, and consider the shocks that they could be exposed to as a result of adverse developments in
the economy or the financial market.
In practice lending has continued to be primarily in the form of short-term loans. Last June such
transactions accounted for 35 per cent of the total credit granted to non-financial companies, basically
unchanged compared with the preceding years. With reference to the companies surveyed by the
Company Accounts Data Service, lengthening of maturities is restricted mainly to companies in
critical conditions that require their debt to be restructured.
The tendency of credit to be short-term has often been seen as related to the practice of borrowing
from several banks, which undermines the discipline the banking system can impose on borrowers
compared with what is possible with relationship banking.
The consolidation of the Italian banking system is leading to less fragmented credit relationships; it
requires banks to adjust their policies and organizational arrangements with a view to establishing
relationships with customers in which more attention is paid to their long-term needs and the
development of suitable forms of corporate finance.
Conclusions
International experience clearly shows that the stability of banking systems depends above all on the
solidity of the real economy and its ability to follow a path of sustained and balanced growth.
International financial integration offers major opportunities to improve the allocation of savings on a
world scale, accompanied, however, by the risk of unprecedentedly large and sudden systemic crises.
Without detracting from the importance of economic and monetary policies or of the action of the
bodies entrusted with safeguarding macrofinancial stability, the fundamental aspect consists in the
steps banks take to strengthen their risk-management policies and procedures and to counter the
pressure on their margins arising from the growth in competition in national and international markets.
In Europe the presence of many large global firms of high standing, the dismantling of the barriers
inherent in the denomination of securities in different currencies and the possibility of referring to a
single yield curve will foster the development of the market for private sector securities.
For large companies, whose operations cover several national markets and whose financial
management involves several different currencies, the new single currency regime will reduce the
need to do business with a plurality of banks. A reduction in the demand for credit from prime
companies appears possible, the spread of private sector securities may cause problems for
fund-raising. Though marked by national traits in legal and fiscal matters, the configuration of the
financial system of the European Union will becorne more similar to that of the Anglo-Saxon systems.
The profitability of traditional lending to enterprises is likely to come under pressure; the need to
develop business with different categories of customers and to look for profit opportunities in foreign
markets will involve both old and new credit risks.
The changes under way make it necessary to grasp the growth opportunities offered by corporate
finance services; this will give further impetus to the spread of financial techniques for the
management of risk and to the growth of the securitization market.
The ability to manage risks, above all credit risk, efficiently, will be a competitive strength of crucial
importance; it requires intermediaries to adopt the innovations made possible by today's statistical
models and financial techniques, to integrate them into their internal organizations, and to develop the
necessary professional skills.
Active management of the loan portfolio, frequently indicated as the new frontier in lending, cannot be
independent of the effectiveness of the traditional procedures, from the assessment of creditworthiness
to the constant monitoring of loan performance.
In a market such as Italy's, in which very little recourse has been made to rating by specialized
agencies, banks lacking an internal rating system sound enough to be approved by the supervisory
authorities would find themselves at a competitive disadvantage. Businesses of high standing would
stand to obtain better conditions from other banks able to apply capital charges more consistent with
the riskiness of the financing.
The revision of the capital adequacy framework is a major challenge for Italian banks. The decisions
regarding the formulation of the systems for classifying credit risk will have to be taken according to
the internationally agreed timetable, in the knowledge that the trend is towards greater use of internal
models.
The Italian banking system has a good knowledge of the world of small and medium-sized enterprises
deriving from its close contact with local economies. In constructing systems for the management of
credit risk, it can count on statistical sources that are not always available in other countries, such as
the Company Accounts Data Service and the Central Credit Register.
Banks are becoming increasingly aware of the challenge; they have the necessary capital, know-how
and organizational ability.
On the other side the limited availability of external ratings and the small size of the private capital
market could prove a serious obstacle to Italian enterprises' efforts to diversify their sources of
financing and reduce their average cost of borrowing. One is struck, once again, by the competitive
disadvantage at which the Italian economy stands owing to the smallness of the share and bond
markets.
The Bank of Italy is stimulating and supporting the efforts of the banking system to modernize its
techniques for managing credit risk. It has taken steps to ensure the proposed new regulations are
widely disseminated and has launched consultations with bankers aimed at jointly assessing the
characteristics that internal ratings will need to have for prudential purposes.
Discussions will also be held with banks as part of normal supervisory activity and the Bank will
participate in the ad hoc working group set up by ABI, the Italian Bankers' Association. In addition,
the Bank of Italy w