Sound credit risk assessment and valuation for loans

Note: This consultative document has been superseded by the final version of June 2006.

Objective and summary

1. This paper is intended to provide banks and supervisors with guidance on sound credit risk assessment and valuation policies and practices for loans regardless of the accounting framework applied. As such, the principles in this paper are intended to be consistent with those set forth in the International Financial Reporting Standards (IFRS) applicable to loan impairment. Specifically, the paper addresses how common data and processes may be used for credit risk assessment, accounting and capital adequacy purposes and highlights provisioning concepts that are consistent in prudential and accounting frameworks. This guidance focuses on policies and practices that the Basel Committee on Banking Supervision believes will promote sound credit risk assessment and controls.
2. The practices presented here address sound credit risk assessment, valuation and control processes for banks, and the responsibilities of the board of directors and senior management for maintaining aggregate provisions for loan losses. The paper also discusses general guidelines for how supervisors should evaluate the effectiveness of a bank's credit risk policies when assessing the adequacy of a bank's credit risk assessment and regulatory capital.
3. Supervisors expect a bank's credit risk assessment and valuation policies and practices to be consistent with prudential guidelines and applicable accounting frameworks. This Basel Committee guidance presumes that banks are following a robust accounting framework. This paper is not intended to set forth additional accounting requirements for provisions for loan losses beyond those established by accounting standard setters. Nor is it intended to bridge provisioning for credit risk assessment for accounting purposes to capital adequacy measures. The Committee recognises that responsibility for compliance with accounting standards rests with a bank's senior management and board of directors, and in most cases is subject to verification through formal external audit. Moreover, a variety of public bodies oversee this process, such as securities regulators and regulators of auditors.
4. The Basel Committee has developed separate papers on a number of related topics in the area of credit risk including credit risk modelling and credit risk management. Banking supervisors promote sound credit risk assessment and valuation policies because they have a natural interest in sound and prudent credit risk assessment and valuation policies and practices utilised by banks. Experience indicates that a significant cause of bank failures is poor credit quality and credit risk assessment. Failure to identify and recognise deterioration in credit quality in a timely manner can aggravate and prolong the problem. Thus, inadequate credit risk assessment policies and procedures, which may lead to inadequate and untimely recognition and measurement of loan losses, undermine the usefulness of capital requirements and hamper proper assessment and control of a bank's credit risk exposure.
5. In the Basel Core Principles, the Committee defines minimum requirements for an effective banking supervisory system and discusses arrangements to promote stability in financial markets. In particular, certain Core Principles require banking supervisors to be satisfied that banks have and adhere to adequate policies, practices and procedures for evaluating the quality of assets and the adequacy of loan loss provisions, enabling the supervisor to obtain a true and fair view of the financial condition of the bank and the profitability of its business.
6. The discussion of credit risk regulatory capital requirements in this document primarily focuses on the use of the Advanced Internal Ratings-based approach under Basel II. Nevertheless, since this paper discusses certain of the Basel Core Principles, it is relevant to all banks irrespective of the approach they use in the calculation of credit risk regulatory capital requirements under Basel II. However, the extent to which the sound practices are implemented should reflect the scope and complexity of an individual bank's operations. As the legal powers of supervisory agencies, in particular regarding accounting issues, vary between jurisdictions, the paper is intended to only provide sound credit risk assessment practice guidance.
7. The focus of this paper is on sound credit risk assessment and valuation for loans carried at amortised cost. Therefore, the paper does not explicitly discuss these processes with respect to loans carried at fair value or at the lesser of amortised cost or fair value. Credit risk is of course present in bank assets other than loans carried at amortised cost and in off-balance-sheet exposures. While credit risk assessment and valuation practices relating to such other bank assets and exposures are generally outside the scope of this paper, the Basel Committee believes that banks should ensure that sound credit risk assessment policies and practices are in place in these areas and that credit risk is properly considered in the valuation of these assets and exposures. Further, a bank should aggregate all exposures to assess the overall credit risk to the institution. Thus, some of the principles in this paper should be helpful to banks and their supervisors in addressing credit risk assessment and valuation issues pertaining to assets other than loans carried at amortised cost and other credit exposures.
8. Comments from the public on all aspects of the consultative paper are welcome by 28 February 2006. These should be addressed to the Basel Committee at the following address:

   Basel Committee on Banking Supervision
   Bank for International Settlements
   Centralbahnplatz 2
   CH-4002 Basel
   Switzerland

   Alternatively, comments may be sent via e-mail to baselcommittee@bis.org.