Currently the banking sector is in complete transformation and develops more and more complex financial operations. The Cooke ratio device was introduced in 1988. With many limits, it did not allow banks to minimize their risks.
The Basle 2 Committee is always in charge of formalizing the worldwide recommendation in order to securitize the banking industry. As a consequence, this committee took decisions to create a new ratio. This new reform aimed at taking into account the existent risk of banks. During many years, the different actors of the banking sector consulted each other and launched a new device in 2004. It was implementing inside the banking sector at the beginning of this year.
In order to strengthen the solidity and the stability of banking industry at a high level, the new reform is based on three pillars, which are very important each others. First of all the equity capital's exigency was already materialized by the solvability ratio. But now there are two other pillars related to the company's behavior. The first one is related to the high cooperation of different banking control's entities. And the second one concerns the quality of communication with investors about the risk status of the company.
Accordingly the banks will be more controlled and will have to prove that they will be able to manage their risks efficiently. In order to preserve an excellent image, they have to take a clear commercial strategy and sometimes being opposed to some types of operations.
In January, the new solvability ratio called Mc Donough was introduced in order to replace the Cooke ratio. The main objective of this innovative ratio is to maintain a certain level of equity capital in order to avoid operational losses and consequently weaken their financial prosperity.
Despite this new reform, the equity capital's exigency is always composed of 8% weighted resources, but the risk parameter has involved. Firstly, this perimeter takes not only into account the credit risk but the market risk and the operational risk too.
In fact, with more sophisticated products and an increasing dependence related to the new technologies, the financial establishments are more and more exposed to the technical breakdown or human failures, which could create financial losses. With the consideration of operational risks, the banks have to consider all types of risks, to record them and finally to limit them. Its introduction is too recent to measure the real impacts. However we could be able to know the cost of equity capital for each operation and realize that some operations are very expensive, so they could be abandoned or subcontracted.
The newel of this reform could be appreciated in the calculation methodology of the different type of risks. This reform aims at giving more responsibility to the financial institution and allows them to allocate the equity capital compared to the level of risk concerning each operation. Each bank is able to calculate internally their different risks. In order to determine each type of risks, the banks should choice between the standard method and their internal method. For example to calculate the credit risk, they can take four parameters: the probability of default (PD), the exposure at default (EAD), the loss given default (LGD) and the maturity (M) of the device.
Consequently banks can, if they would like, implement a device capable to determining internally of these parameters; in order to allocate the necessary amount of capital equity for each operation. If the bank is not able to implement its own calculation system, it can use the standard model by default.
In that case, as under the ratio Cooke, the balanced commitments are determined by applying a coefficient of weighting concerning the nature of the borrower (governments, banks, companies ). But a difference is brought compared to the old ratio, and not the slightest, because the rating of this last one is henceforth taken into account. Before all the companies were balanced in 100 % whom they are in maid or poor health, maintaining this percentage spreads out from 20 % to 150 % in accordance with the rating of the company allocated by rating agencies.
Within the framework of the calculation of each risk, financial establishments thus have the choice between the standard model and their internal model. The first one has for main advantage a big simplicity but turns out finally much more consumers in stockholders' equity. Firstly it should be used by the financial institutions of small size because they can not spend a lot of money to develop sophisticated and expensive models to make their own rating.
Consequently the utilizations of several calculation methods can create some distortion's situation of competition between the financial institutions.
Someone will go out winning of this reform while the others cannot any more be present on certain types of signatures because too expensive in stockholders' equity. In this paper, a simulation of credit with a company (with an average rating) was made, on the one hand with a standard method and on the other hand from an internal rating's method. The result is rather suggestive because the mobilization in stockholders' equity is 65 % more important in standard method.
So, the market of the corporate credit will necessarily be allocated. Eventually, the healthy companies having a weak probability of defect will finance easily and at a lower cost while the most fragile will have to support, via a penalizing pricing, their high risk.
[...] Measures, however, attempt to treat the issue of trade-offs among risks, using a common methodology to transform the specific risks to firm-level exposure. In addition, both can examine the correlation of different risks and the extent to which they can, or should be viewed as, offsetting. As a practical matter, however, most, if not all, of these models do not view this array of risks as a standard portfolio problem. Rather, they separately evaluate each risk and aggregate total exposure by simple addition. As a result, much is lost in the aggregation. [...]
[...] Nonetheless, the techniques employed by those that define the industry standard could use some improvement. By category, recommended areas where additional analytic work would be desirable are listed below. CREDIT RISK The evaluation of credit rating continues to be an imprecise process. Over time, this approach needs to be standardized across institutions and across borrowers. In addition, its rating procedures need to be made compatible with rating systems elsewhere in the capital market. Credit losses, currently vaguely related to credit rating, need to be closely tracked. [...]
[...] In fact they could decrease their LGD and the EAD of the operation, because in case of default the bank could catch the securities. The cash collateral could have a positive effect on the PD. The reduction risk factor should be valorized at their minimal level, except the aircraft, and the vessels reviewed half-yearly. The bonds are in the same case, because they are reviewed on a quarterly basis. We will apply to certain operation a below per rating about the volatility or the currency. [...]
[...] These last ones would have fewer and fewer interlocutors in front of them. Consequently, they would undergo more and more the prices practiced by the big establishments without being really able to let the competition be freely made. To conclude this section, Basel II represents a long-term opportunity but with budget issues and operating profits under pressure worldwide, the initial investments banks must make to comply with the New Agreement also represent a short-term challenge. Over time, however, the improvements in risk management Basel II is intended to drive may enhance risk culture, reduce volatility of all risks, lower provision for bad debts, reduce operational losses, improve the institutions' external ratings, and thereby help ensure access to capital markets and raise organizational efficiency. [...]
[...] In this strong legal constraint, commercial add and operational stakes for the financial players. Indeed, in all the financial business lines(jobs) of provision of services to the private individuals, the practices, the business models and the information systems were conceived to operate In a given regulatory environment, and can be adapted only to the price of investments Considerable. Furthermore, certain players (French in particular) are subjected to rules of consumer's protection more binding than the others and deployed heavy infrastructures being able to respect them. [...]
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