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March 09, 2008
Credit Risk / Investment Risk- two sides of the same coin?
Recently, I was talking to a senior risk manager in one of the offshore banks based in this region. This particular bank had private equity exposures, which are required to be classified in the banking book as per local regulations. Fair enough.
But what followed was confusing. Since private equity which has investment or price risk is classified alongside credit exposures, and the same advanced model (PD/LGD) is used to determine capital charges, the bank equated investment risk with credit risk and treated them as equivalent for practical purposes! While this was not what Basel II set out to achieve, nevertheless there are some areas with respect to equity exposures in the banking book which needs to be debated.
Risk weights for credit exposures vary from 0% to 150%. Capital is held is to protect against both migration risk and default risk. On the other hand, equity exposures in the banking book are weighted at 300% (publicly traded) or 400% (other equity holdings). The higher risk weights for equity exposures reflect the higher levels of unexpected losses as well as the greater variability of returns in equity exposures. On a portfolio basis, credit risks may be granular i.e. distributed across large number of clients, while equity exposures may be lumpy in nature. In addition, the additional risk charge (100%) for non traded equities reflects the liquidity risk in fire-sale situations. These three factors explains why price risk in equity investments is not the same as credit risk even if they belong to the same banking book.
The confusion is understandable if one looks at models based approach for estimating investment risk for equity exposures. Normally, the PD/LGD model is associated with the credit risk estimation; pray how is this relevant for estimating the investment risk of equity exposures?
In fact the initial consultative papers by Basel acknowledge that default risk is itself a difficult concept to define for equity. It goes on to clarify that the PD/LGD approach, incorporates elements of both general market and idiosyncratic (i.e. specific) risk associated with equity holdings. This unfortunately, is not readily apparent or explained.
If banks decide to use the PD/LGD model for measuring credit risk (oops! Sorry, investment risk!), there are further issues. Banks are required to estimate the PD of a corporate equity exposure in the same way that it would do for a debt exposure for that company.
What happens when the bank does not have a debt exposure for which it has an equity exposure? In such cases, it is difficult for banks to have access to information. Basel recognises that in such cases, “the equity definition of default is likely, on average, to deliver a later outcome than the corporate definition”. In recognition of this lagged/delayed effect, Basel has recommended a 1.5 scaling factor be applied to the PD/LGD weights in such circumstances.
Given these difficulties, most banks would prefer to stick to the simple risk weights method, rather than venture into the models based approach. While this means additional capital charges, it is not a problem for many Gulf based banks, as they have much higher capital adequacy levels than required by their regulators. That is, as long as credit risk and investment risk is not equated and are treated differently!
Posted by aaaaaaa at March 9, 2008 11:13 AM
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