Are Credit Models Getting a Beating?

  5 min 11 sec to read

The events of high magnitude fraud in PNB clearly reveal that inappropriate internal control and lack of adequate supervision can inflict severe damage not only to the profitability of the bank but also to the reputation of the institution.


It has now become a prime topic for debate- the recent banking fraud to the extent of INR 12K crores at Punjab National Bank (PNB), the second largest PublicSector Bank (PSB) in India. The media has been very critical about the incident and drew the attention of the whole nation as to how public money has been looted.

Indeed, the magnitude of the fraud is horrendously high and it raised a very relevant question, whether it was an isolated incident or are all PSBs suffering from the same weakness. However, this has yet to be identified by the government and the Reserve Bank of India.

Many senior banking professionals have felt that the incident is a classic example of failure in governance. Another school of thought has argued in a different way. They have raised the very fundamental issue of inappropriate risk appraisal and less than adequate monitoring systems of the PSBs. Nevertheless, everyone felt that the basic integrity of the individuals involved in the process of risk management was called into questioned. They believed that an effective risk management system could have prevented such a major blow to PNB.

One can very well remember that in September 1998, a few days before one of the biggest financial collapses, in Europe, near bankruptcy of long term capital markets, more than 200 credit experts and their regulators spent two days deep underground, thrashing out the virtues and vices of credit risk modelling. At the end of the session a panel including a trio of European regulators concluded that the models were “half- baked” and could not be used to set regulatory capital.

It became a challenge for the modellers who knew that they would have a battle to persuade the regulators of their case. The modellers wanted the regulators to accept that banks’ internal risk models should be used to help determine a level of regulatory capital for credit risk (i.e. default risk). This would allow banks to benefit from the portfolio effect of diversified credit risk, by which they argue that the models were designed to identify and to reduce their regulatory capital accordingly. It would also better identify the concentration of risks, and in some areas indicate that an increase in regulatory capital might be required.

The four best known models on offer were (and still are) credit metrics (JP Morgan), credit risk (Credit Suisse), KMV (by KMV Corp, a developer of credit risk measurement software), and credit portfolio -view (Mckinsey & Company). 

Each has its strengths and weaknesses.`In June 1999, the Basel Committee on Banking Supervision provided a new framework for setting banks’ regulatory capital based on three guiding principles:

Banks would be able to use their own internal measures to determine the credit exposure, and would be used to set an amount of regulatory capital to allocate as a cushion.

A continual review by supervisors, rather than monthly or yearly reporting, would be a factor in setting the regulatory capital. A good general standard of risk management would be rewarded by a lower capital charge.

As far as possible, public disclosure of bank’s risk management processes and numbers would bring in market forces as a regulatory mechanism.

A further important innovation in the Basel 2 framework was the attempt to factor in so called “operational risk”. It is important to remember that the Basel committee and the banks took eighteen months to come up with a definition of operational risk as: “The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.”

However, one can notice that the definition did not include business risk for obvious reasons as that is an integral part of credit risk assessment. 

Our recent experiences of the Indian financial market incident indicate that defining operational risk has not brought banks much closer to quantifying it, especially the high-cost low-frequency events such as fraud, rogue trading etc. The events of high magnitude fraud in PNB clearly reveal that inappropriate internal control and lack of adequate supervision can inflict severe damage not only to the profitability of the bank but also to the reputation of the institution. The cascading effect of this fraud in the banking industry has deeply wounded the peoples’ confidence in the system and has been reflected in the sharp decline in the stock prices of the PSBs. In addition, the Indian government, as a part of its well thought of decision, has been injecting additional capital to the PSBs for strengthening their regulatory capital and adequacy ratios would now serve only a limited purpose.

This is not only a lesson for the Indian regulators but also could serve the purpose of alerting the neighbouring emerging markets to revisit the quality of risk assessment and risk management framework of the banks and financial institutions. This alarm bell must exhort the regulators to seriously reassess their supervision system and also the adequacy and appropriateness of manpower.  

The Indian investors are now in a dilemma as to how to manage their investments in the PSB shares going forward. We also need to watch and wait to see what steps the regulators will take to prevent the recurrence of high magnitude control failure.

Mundul is former member of Board of Director of Standard Chartered Bank, Nepal.

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