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Exploring risk based pricing for corporate loans
Previously I wrote about an approach to pricing loans, where the spread is set to cover expected losses from default, and to make a return on capital allocated. In this article I use the framework to explore the drivers of credit spreads that banks would calculate if they used the Basel IRB formula to calculate the amount of capital required.
Some banks may use regulatory capital to derive capital as this reflects the amount of regulatory capital required for the loan. The regulatory approach as specified by BCBS captures key drivers of risk such as probability of default, loss given default, systemic risk, and term.
This simple pricing approach reveals some interesting dynamics of the required credit spread. For example, with higher rated securities, the spread is driven by capital requirements and not the expected loss. Drivers of capital such as correlation between defaults and term to maturity have a larger influence.
Sound capital planning practices according to the Basel Committee
The Basel Committee on Banking Supervision (BCBS) released a paper titled “A Sound Capital Planning Process: Fundamental Elements” in January 2014. This paper does not propose changes to standards or capital requirements. Instead, it reports on a study carried out by BCBS on the capital planning process at a number of banks.
The paper has a good overview of what is good capital planning and is worth reading if you work in bank capital management. It covers the following fundamental elements: internal control and governance, capital policy and risk capture, forward-looking view and management framework for preserving capital.
Banks must forecast future capital needs under a range of conditions as part of their internal capital adequacy assessment process (ICAAP). ICAAP is an part of Basel 2, Pillar 2 requirements. The BCBS document “Enhancements to the Basel II framework” outlined measures to strengthen Pillar 2 requirements. For Australian banks, the requirements are set out in Australian Prudential Regulation Authority’s standards and practice guides (APS 110 and CPG 110 respectively).
A number of the components of a sound capital planning process are already requirements under the current standards or guidance that Australian banks need to follow. (more…)
Risk Return Sweet Spot 