The increasing use of credit portfolio risk models by financial institutions will accelerate with the establishment of Basel II, says Fitch Ratings in a news report.

“Basel II adapts many of the concepts and techniques used by large financial institutions in their own internal credit risk models for supervisory purposes,” says Dr. Gary van Vuuren, senior director in Fitch’s Financial Institutions team. “Fitch believes that the anticipated convergence between economic capital and regulatory capital frameworks has been a positive impetus to further refine and more broadly spread advanced risk measurement and management practices such as credit portfolio risk modelling amongst financial institutions.”

In its report, Fitch outlines the factors that influence the degree of comfort the agency derives from an institution’s credit risk models in the assignment of ratings.

“Credit risk models form a very important part of risk management and are a vital input into the pricing of products and services,” says Krishnan Ramadurai, managing director in Fitch’s Financial Institutions team. “The understanding of risk on an aggregate basis and an assessment of how these risks associated with single borrowers interact with each other is very difficult to achieve in the absence of some kind of risk model, especially where risks are complex. It is also Fitch’s opinion that while measuring risks is a necessity, to achieve full economic benefit from the models, their output should be an influencing factor in decision-making within an institution.”

To be effective models should be chosen that provide a strong fit between their capabilities, assumptions and the properties of the portfolio, it said. “For example, some contemporary credit risk models employ a single-factor model framework that may be appropriate for highly diverse portfolios as found in retail banking or SME divisions, but can only rarely be applied to corporate portfolios. Thus it is essential to ensure that the model is appropriate for the underlying business,” Fitch explains.

This paper is the first of a series that will address the role of internal economic capital models in assessing risk appetite and capital adequacy in financial institutions. Other papers addressing related issues such as assessing market risk and operational risks both individually and in combination with credit risk and how these risks relate to economic capital models will follow.