Sound credit risk assessment and valuation for loans

Objective and summary

This paper is being issued by the Basel Committee on Banking Supervision to address how common data and processes related to loans may be used for assessing credit risk, accounting for loan impairment and determining regulatory capital requirements. The guidance supersedes Sound practices for loan accounting and disclosure, published by the Committee in July 1999, and is structured around ten principles that fall within two broad categories:

Supervisory expectations concerning sound credit risk assessment and valuation for loans

1. The bank's board of directors and senior management are responsible for ensuring that the banks have appropriate credit risk assessment processes and effective internal controls commensurate with the size, nature and complexity of the bank's lending operations to consistently determine provisions for loan losses in accordance with the bank's stated policies and procedures, the applicable accounting framework and supervisory guidance.
2. Banks should have a system in place to reliably classify loans on the basis of credit risk.
3. A bank's policies should appropriately address validation of any internal credit risk assessment models.
4. A bank should adopt and document a sound loan loss methodology, which addresses credit risk assessment policies, procedures and controls for assessing credit risk, identifying problem loans and determining loan loss provisions in a timely manner.
5. A bank's aggregate amount of individual and collectively assessed loan loss provisions should be adequate to absorb estimated credit losses in the loan portfolio.
6. A bank's use of experienced credit judgement and reasonable estimates are an essential part of the recognition and measurement of loan losses.
7. A bank's credit risk assessment process for loans should provide the bank with the necessary tools, procedures and observable data to use for assessing credit risk, accounting for impairment of loans and for determining regulatory capital requirements.

Supervisory evaluation of credit risk assessment for loans, controls and capital adequacy

1. Banking supervisors should periodically evaluate the effectiveness of a bank's credit risk policies and practices for assessing loan quality.
2. Banking supervisors should be satisfied that the methods employed by a bank to calculate loan loss provisions produce a reasonable and prudent measurement of estimated credit losses in the loan portfolio that are recognized in a timely manner.
3. Banking supervisors should consider credit risk assessment and valuation policies and practices when assessing a bank's capital adequacy.