Risk Scores in Global Banks
The primary uses of Risk Scores in Global Banks are:
* mininum capital requirements
* default probability / loss given default
* country risk limits & asset allocation
Global banks and insurance companies are required by their regulators to maintain minimum levels of capital -- linked to measures of country risk. Banks have the option of using those ratings assigned by the major CRAs (the Standard Approach) or internal risk-based systems (IRBs), based on their own country risk scales and assessments. These have become highly technical and subject to almost continuous revision since 2006. This reflects the complex structures of global financial institutions, and the tension between banks seeking to secure profits in a global financial system and regulators seeking to limit harm arising from high-risk behaviour. Insurance companies are now encountering similar scrutiny as they must now allocate higher capital under Solvency II rules.
Standard Approach to Capital
The Standard Approach, first set out in Basle II (2006), permitted banks to use the risk ratings of major credit rating agencies (CRAs) to calculate the minimum capital required to be held against the banks's sovereign exposures. This enabled banks to avoid making their own risk judgments, but also left them vulnerable to volatile shifts in CRA risk ratings.
Problems with the Standard Approach
During the 2010/12 sovereign crisis, the reliance on CRAs created serious conflict with European governments as frequent multi-step rating reductions cut off many sovereigns from institutional funding. Steps to supplant the CRAs have met with mixed success. The IMF, ECB and European Systemic Risk Board are leading efforts to heighten attention to sector-specific concerns and liquidity risks. Over time, this will push analysts to develop a layered approach to risk, with deeper sectoral analysis and explicit liquidity risk measures.
Internal Risk-Based Approaches
Major banks have long used internal risk monitoring systems to estimate capital requirements and set loan loss reserves. Basle II permitted larger banks to use their own internal risk rating systems (IRBs) to forecast the Probability of Default, calculate their Exposure at Default, and estimate Loss Given Default. These became the cornerstones of Basle II capital rules. Recent official studies show enormous discrepencies between the capital estimates arising from different bank systems. This led to a tightening of supervision, mandatory stress tests by supervisors, and more critical evaluation of risk scoring systems, include those for sovereigns.
Since the Great Financial Crisis, banking supervisors have expanded the reach of the earlier Basle accords. New Basle III rules cover the Quality of Capital, ways to contain Leverage, and measures to track and limit Liquidity Risk. Each area is complex, and reflect years of negotiations between banks and their regulators. The diagrams below show the broad scope of the new regulations.