Basel III brings opportunity to optimize.

Author:Lois, Shannon
Position:Executive Essay

These are challenging times for financial institutions. Still feeling the impact of the financial crisis, the industry endures increased oversight, declining margins and fierce competition--all in a lackluster economy.

Large bank holding companies (BHCs) are subject to closer regulatory scrutiny. As part of the oversight, the Federal Reserve Board (FRB) conducts annual assessments, including stress tests, of the capital planning processes of BHCs to ensure these institutions can continue operations in the event of economic distress. The Fed expects banks to have credible plans showing that they have adequate capital to continue to lend, even under adverse economic conditions, which will ensure that banks are not overly leveraged.

Investigation and modeling of interrelations between macroeconomic factors and portfolio performance is at the foundation of regulatory compliance. With the complexities of, for example, a mortgage portfolio coupled with the instructions from each of the regulations, finding the right balance between the analytics and portfolio requirements and the business and capital allocation is a must in today's environment.

Stress-testing processes have to be integrated into the business and will be used to support capital and cash-flow management. Using macroeconomic models to generate forecasts and alternative (stressed) scenarios permits the generation of consistent values for identified economic drivers and portfolio risk factors--i.e., probability of default (PD), loss given default (LGD) and exposure at default (EAD).

In addition to meeting the requirements of Basel III and the Federal Reserve's Comprehensive Capital Analysis and Review (CCAR), institutions commit sizable resources to tasks that offer few quantifiable returns. Nevertheless, in addition to ensuring they don't find themselves in a trillion-dollar hole, audit responsibilities offer an opportunity for a bottom-up approach to credit strategies, which can also be applied to other business processes.

Basel III advises banks to measure credit risk: "Banks should have methodologies that enable them to assess the credit risk involved in exposures to individual borrowers or counterparties as well as at the portfolio level," reads paragraph 733 of the Basel text.

Sounds reasonable, and a bit self-evident; banks should be able to assess their credit risk, whether Basel mandates it or not.

Optimizing assets

In response to the challenges of CCAR and Basel, many...

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