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Basel II Services - What can it do for me?

Complying with Basel 2The framework for Basel II compels the supervisors to ensure that banks implement credit rating techniques that represent their particular risk profile. Besides the risk inputs (Probability of Default (PD), Loss Given Default (LGD) & Exposure at Default (EAD) calculation, the final Basel accord includes the “use test” requirement which is the requirement for a firm to use an advanced approach more widely in its business and not merely for calculation of regulatory capital.

Therefore many financial institutions are required to make considerable changes in their approach to risk management (i.e. infrastructure, systems, processes, data requirements).

How can we help you?

We enabling you to achieve profitable compliance with the New Capital Accord. Experian is a leading provider of products and services for the New Basel Capital Accord (Basel II). It works closely with existing banking partners and with a broad cross-section of financial institutions and national regulators.

A few key facts

The Decision Analytics solution for Basel II includes:

  • Scoring and analytics
    Development of pooled and customised models for probability of default, exposure at default and loss given default estimation. The risk estimates are used in the capital adequacy calculation as well as the processes to manage business risk, fulfilling the requirements of the ‘use test’.
  • Monitoring and Reporting system and processes
    Reporting and strategy reviews are critical for monitoring and continually validating models, portfolio management and business processes.
  • Enterprise wide decisioning
    The central decision engine, scorecards and strategies, support automation of decisions and efficient management of risk. Provides delivery of strategies for portfolios and customer processes as well as implementing Basel II requirements.
  • Data Warehouse
    The data warehouse has been specifically designed to provide store and access the right quality and quantity of data.
  • Documentation
    Assistance in the preparation of up to date and detailed documentation, critical for control and external and internal audit of the systems.
  • Consulting
    Experienced Basel II consultants to review, advise and assist in implementation.

Probability of Default (PD), Loss Given Default (LGD) and Exposure at Default (EAD).

  • Clear summary of minimum capital requirement, exposures, risk weighted analysis and average PD, LGD and EAD, split by consumer and SME sub portfolios
  • Detailed analysis and reports for PD, LGD and EAD
  • Best fit forecasts to assess and manage the impact of changing values over time
  • User selection of Capital Adequacy approach for calculations
  • Stress testing with analysis of the likely impact on capital requirements

We provide a range of Basel solutions covering the key components necessary for compliance with the requirements:

Consulting

Based on a comprehensive understanding of Basel II and its validation requirements gained from extensive experience of working globally with banking organisations and supervisors worldwide. 

Model development

Model development and calibration for the complete set of Basel models including generic models and those based on pooled data. 

Quantitative and qualitative validation

Validation of both new and existing models carried out as a service on a consulting basis.

Flexible decision support

We provide software capable of implementing Basel ratings and fulfilling the ‘Use Test’ requirements.

Reporting and monitoring solutions

Expert report modules for scorecard diagnostics and Basel for a complete view of your retail and SME portfolios. A summary report highlights the key Basel measures by each sub-portfolio and more detailed reports guide the user through the structured analysis for PD, LGD and EAD.

For more than 25 years, Experian has been providing risk management solutions to the financial sector. Throughout that time it has worked particularly closely with banks to help them manage the customer lifecycle of their retail and small and medium enterprise (SME) portfolios from acquisition through to customer management and debt control. 

The requirements of Basel are an extension of this discipline and fall naturally into the skill set that has been developed over the last two decades.  As a leading provider of solutions for Basel, Experian works closely with a broad cross-section of banking institutions and national regulators to deliver profitability through compliance.  We will continue working with banks and supervisors around the world to build risk management solutions that deliver profitability through compliance.

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The Decision Analytics solution for Basel II includes:

  • Scoring and analytics
    Development of pooled and customised models for probability of default, exposure at default and loss given default estimation. The risk estimates are used in the capital adequacy calculation as well as the processes to manage business risk, fulfilling the requirements of the ‘use test’.
  • Monitoring and Reporting system and processes
    Reporting and strategy reviews are critical for monitoring and continually validating models, portfolio management and business processes.
  • Enterprise wide decisioning
    The central decision engine, scorecards and strategies, support automation of decisions and efficient management of risk. Provides delivery of strategies for portfolios and customer processes as well as implementing Basel II requirements.
  • Data Warehouse
    The data warehouse has been specifically designed to provide store and access the right quality and quantity of data.
  • Documentation
    Assistance in the preparation of up to date and detailed documentation, critical for control and external and internal audit of the systems.
  • Consulting
    Experienced Basel II consultants to review, advise and assist in implementation.

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Experian Decision Analytics has recently delivered a project to design, develop and implement a best practice solution for the retail exposures of a leading bank with more than five million customers. The solution is helping the bank achieve compliance with the IRB approaches in its retail account portfolios.

The solution provides the bank with an infrastructure in advance of most of its direct competitors and in line with international best practice. The bank is currently on track to meet the retail credit IRB requirements for Basel compliance. Overall, the project has brought benefits associated with enhanced credit risk management as well as the projected compliance with Basel.

As part of the solution, models were developed for PD, LGD and EAD.

Before implementation, the ratings models were validated to ensure the inputs into the ratings process were accurate and provide effective measurement. This initial qualitative and quantitative validation of the ratings models and model development process is discussed here in more detail. The bank is currently implementing tools and processes for ongoing performance monitoring and validation of the ratings systems and loss estimates to ensure continuing accuracy over time in compliance with Basel requirements. It is also collating data in order to carry out ‘out-of-time’ validation to complement the current ‘out-of-sample’ validation methodology.

The elements of the initial validation process included a data audit and cleansing exercise to ensure data integrity and a range of qualitative and quantitative validation elements as required by Basel.

Qualitative elements

A number of checklists incorporating all aspects of model development were used to formalise the qualitative validation process. This included data audits, choice of methodologies, samples and estimation methods.

Data integrity

The data sample used for model development incorporated both application and behavioural data from the bank to achieve the most representative sample. Before model development took place, an extensive data audit was completed to ensure the integrity of the development sample. Several issues were identified and resolved including data errors, blank and incomplete fields and inactive accounts flagged incorrectly.

Documentation

As an integral part of the development process, every stage has been documented and recorded in line with the requirements of the Accord. The model design information alone is several hundred pages and covers every aspect of the decisions made and analysis undertaken.

Reporting and monitoring

The bank has also implemented an advanced reporting and monitoring solution in order to manage data and monitor the performance of the ratings models. The central data warehouse is fully integrated into the business systems and collects, manages and maintains application and on-going performance data for operational and strategic analysis.

‘Use Test’

The implementation of new risk management systems and processes, means that the bank is now fulfilling the ‘Use Test’ requirements of Basel, with the ratings representing an integral part of business and risk management processes.

The models are used across the customer life-cycle, with the ratings forming part of the assessment for accept/reject and pricing in the new business environment and determining strategies for customer management including limit management and collections.

Quantitative elements

Validation was carried out to measure population stability, rating model performance and risk parameter accuracy. A ‘hold-out’ sample of 20% of the development sample was used to test the model performance across the whole population. Overall all the models performed at or above industry benchmark levels and exhibited strong consistency across development and hold-out samples. The development sample demonstrated high predictive power for PD and exceeded the industry benchmarks for most portfolios

PD validation tests Gini coefficients and Kolmogorov- Smirnov (K-S) tests were conducted to assess the discriminatory power of the model before comparing the development PD estimates to the PD values observed in the hold-out sample. Overall the PD models showed very high predictive power in line with current best practice. LGD and EAD validation tests

The initial validation tests on the LGD and EAD (strictly speaking the credit conversion factors (CCF) showed that the models were predictive and K-S tests were used to compare the development and hold-out samples.

The strength of LGD models were considerably more powerful for the secured compared with the unsecured portfolios. Best practice around the EAD and LGD validation is still developing, but there is growing acceptance that the strength of these models will be lower than for PD.

Independent review

The work undertaken for the bank was scrutinised by an independent external consultancy who concluded that the approach adopted by the bank and Experian Decision Analytics was sound and consistent and was well aligned with Basel requirements.

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Does your rating system work?

This white paper focuses on the issues of validation and discusses feasible validation approaches covering all aspects of data and process quality, as well as quantitative and qualitative approaches to validation, which address the issue of compliance whilst delivering maximum benefit.

Despite the widespread use of credit scoring throughout the banking industry, it has only come under limited scrutiny until recently. With the introduction of the New Capital Accord (Basel II), the industry now has to comply with requirements for more robust risk management techniques, and within this, mandatory validation.

Validation has always been good practice for financial organisations using scoring models to assess customers. Within the requirements of Basel II, validation is a vital process to ensure and demonstrate the objectivity, accuracy and stability of the ratings system.

The Basel Committee on Banking Supervision, recognising the importance of validation, has created a sub-group to specifically focus on this subject.

The group has published a number of documents outlining the principles and the requirements for validation, which banks now need to adopt and comply with.

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