A Comparative Analysis of Credit Risk Management

Models for Banking Industry Using Simulation

Hsin-Hung Chen1, Ben-Chang Shia2, and Hsiu-Yu Lee1

1
Department of Business Administration, Cheng Shiu University
No.840, Chengcing Rd., Niaosong Dist., Kaohsiung City 83347, Taiwan
mchen@csu.edu.tw, shirley3801329@yahoo.com.tw
2
Department of Statistics and Information Science, Fu Jen Catholic University
025674@mail.fju.edu.tw

Abstract. Risk management is an issue that has become increasingly important.

Basel II Accord has been widely discussed since it was proposed. However, the
comparative analysis of CreditMetrics with Basel II Accord has not been found
in previous literatures. The objective of this study is to compare CreditMetrics
with Basel II Accord using empirical data and simulation programs. Moreover,
the fitness of the standard for Basel II Accord which proposed the minimum
requirement of 8% of capital to risk-weighted assets is discussed in this study.
The records of the data system in a bank listed by the Taiwan Stock Exchange
Corporation (TSEC) were used as the empirical data in this research. The results
showed that the expected loss calculated by the 8% capital ratio defined in Basel
II is clearly lower than the Credit VaR obtained from the CreditMetrics model.

Keywords: Basel II Accord, CreditMetrics, credit risk, Value-at-Risk (VaR).

1 Introduction
Risk management is an issue that has become increasingly important. Financial
institutions compete aggressively for more market shares and customers, and
consequently, they take on more risks [1]. Therefore, the implementation of risk
management within financial institutions is crucial. The risk management attempts to
reduce and manage the risks, increase the benefits, and avoid harm from taking risks
due to default of loan accounts [2]. In the financial sector and banking industry, risk
management is an issue of high interest due to the financial crises of the last two
decades [3]. These crises occurred for various reasons but according to the Basle
Committee, which is the international banking supervisory body, the largest source of
serious banking problems is credit risk which caused by counterparty default. Serious
financial scandals and crises such as the Russian Default and the Tequila crisis are
related to credit risk [1]. Scandals of that type in the 1990s are estimated to have cost at
least $125 billion within the United States. Another indicator of the crucial importance
of credit risk is the fact that in recent years there has been a steady increase of defaults
and bankruptcies and a decline in the creditworthiness of financial institutions
counterparties [4] and [5]. In 2008, the events of sub-prime mortgage and global

Q. Zhou (Ed.): ISAEBD 2011, Part I, CCIS 208, pp. 554562, 2011.
Springer-Verlag Berlin Heidelberg 2011
 A Comparative Analysis of Credit Risk Management Models 555

financial distress occurred. These reasons provided the motivation for the present
authors to explore the issue of credit risk in this study.
In order to improve credit risk management and financial stability for banking
industry, the Bank for International Settlements (BIS) [6], an international organization
that fosters cooperation toward monetary and financial stability, proposed the 1988
Basel Capital Accord (Basel I) and the New Basel Capital Accord in 2001 (Basel II).
The major difference between the two capital accords is that Basel II provides more
flexibility and risk sensitivity in credit risk management than Basel I. Basel II consists

of three mutually reinforcing pillars: Pillar 1 minimum capital requirements, Pillar 2

supervisory review process, and Pillar 3 market discipline [7].
Besides Basel I and Basel II proposed by BIS, J.P. Morgan published CreditMetrics
to evaluate credit risk of loan portfolios in 1997. CreditMetrics approach is based on
credit migration analysis, i.e. the probability of moving from one credit quality to
another, including default, within a given time horizon, which is often taken arbitrarily
as 1 year. While interest rates are assumed to evolve in a deterministic fashion, the
changes in value are related to the eventual migrations in credit quality of the loan
account or obligor upgrades and downgrades as well as default [8].
Basel II Accord has been widely discussed since it was proposed. For example,
Lamy [9] discussed the treatment of credit risk in the new Basel Accord and the results
revealed that the new Basel Accord should encourage A-rated banks to act as liquidity
providers in economic slowdown phases. The issue of credit risk also has been
investigated frequently [10], [11] and[12]. However, CreditMetrics approach was
rarely discussed by empirical analysis. The study of Crouhy et al. [8] has introduced
and reviewed the CreditMetrics approach as well as other credit risk measurement
models, but there was no empirical analysis in that article. Moreover, the comparative
analysis of CreditMetrics with Basel II Accord has not been found in previous
literature. Therefore, the objective of this study is to compare CreditMetrics with Basel
II Accord using empirical data. And the fitness of the standard for Basel II Accord
which proposed the minimum requirement of 8% of capital to risk-weighted assets is
discussed in this study. The records of the data system in a bank listed by the Taiwan
Stock Exchange Corporation (TSEC) are used as the empirical data in this research.
The remainder of this paper is organized as follows. Section 2 introduces the Basel II
proposed by BIS. Section 3 reviews the CreditMetrics approach proposed by JP
Morgan. Section 4 presents the results of empirical analysis including the object of
analysis. Section 5 discusses the managerial implications of the analytical results, and
the last section provides conclusions and suggestions.

2 The New Basel Capital Accord (BASEL II)

According to Saunders and Allen [13], the 1988 Basel International Bank Capital
Accord (Basel I) was essential because it sought to develop a single capital requirement
for credit risk across the major banking countries of the world. A major focus of Basel I
was to differentiate the credit risk of bank, and mortgage obligations (accorded lower
risk weights) from nonblank private sector or commercial loan obligations (accorded
the highest risk weight). All commercial loans implicitly required an 8 percent total
capital requirement, regardless of the innate creditworthiness of the borrower, its