BNL -- Gruppo BNP Paribas Uses SAS® to Comply with Basel II Credit Risk Regulations

Substantial changes in the financial and regulatory environment are calling for banks to revise their credit risk management strategies. An example of this is the New Basel Capital Accord (Basel II), which mandates implementation of a framework that exposes the risk sensitivities that financial institutions face and, as a consequence, the capital requirements they must bear.

In response to the new regulations, the Credit Risk Division of BNL -- Gruppo BNP Paribas turned to SAS to make the transformation toward a Basel II compliant strategy.

Internal Ratings System: New Incentive for Risk Management
The overall purpose of Basel II is to improve capital adequacy assessment; enhance risk measurement and management capabilities; promote thorough and transparent reporting; and encourage banks to improve their risk management processes.

Under Basel II's new "minimum capital requirements," banks are obligated to produce capital adequacy risk measurement calculations for credit risk via either the traditional standardized approach or the new internal ratings-based approaches. The original opinion of the Basel Committee, as defined in the previous 1988 Capital Accord, was to favor the use of ratings by external international credit ratings agencies. However, mandatory use of this approach proved to be detrimental in countries where the external rating system is not very common, such as Italy, putting these countries at a distinct disadvantage.

Recently, the Basel Committee has changed its position and has put the Internal Ratings-Based (IRB) approach of banks on par with the ratings of the external agencies. Now, banks that have appropriate information systems and control procedures in place will be allowed to use their own internal ratings estimates to define and calculate default risk, on the conditions that the robust regulatory standards are met and the internal rating system is validated by the national supervisory authorities.

The introduction of an IRB methodology is significant in that it allows more sensitivity to the level of risk in a bank's portfolio and can incorporate supplementary customer information that is not available externally. Further, the IRB approach emphasizes the goal of more accurate calculations in order to preserve banks' profitability. Therefore, the new internal ratings-based approach is an important option, as it can allow for customization, adapt to individual circumstances (as opposed to the fixed, standardized approach) and help reduce capital requirements.

Credit Risk Rating
One of the first steps financial institutions can take in approaching the Basel II capital adequacy assessment requirements is to implement a model for credit risk rating. Conceptually, the purpose of credit rating is to evaluate the credit-worthiness of customers through a sectional approach which includes analysis of the financial, profit and capital soundness of the enterprise; the evaluation of credit lines; the market in which the enterprise operates; and the qualitative judgment of the enterprise by BNL's account managers. The advantages of credit rating are in improving credit allocation and predicting defaults; monitoring customers' credit risk profiles; releasing resources; and minimizing capital requirements.

BNL decided to initiate the implementation of an internal rating system as an integral part of their credit risk estimation process. Because Basel II stresses the importance of quality control requirements, such as the robustness of the statistical operations systems utilized, BNL looked to SAS to design and implement the new credit risk strategy.

SAS Chosen
SAS created a credit data warehouse to ensure ever-deeper knowledge of the borrowers, as well as a credit risk management model designed to comply with Basel II requirements and to strengthen BNL's competitive edge. The goal of the project was to develop a reliable solution capable of evaluating the probability of customer default, especially those in the corporate segment, and then to use the results as the basis for developing more advanced credit risk management models.

"In order to develop a reliable behavioral 'score' model, we have to process a vast amount of data," explains Giovanni Parrillo, head of the credit policy service at BNL. "To carry out this process we chose SAS solutions, which have proved to be useful, especially at the modeling stage, because of the flexibility they allow us to make rapid changes of specifications and data sampling methods in certain situations." Data is analyzed using SAS to better understand and refine the predictive variables, as well as for easy management of a huge quantity of data.

Benefits of Compliance
SAS' expertise in risk management, data warehousing and facilitation of the transformation process allows BNL to estimate the probability of default via credit rating and to identify which attributes are predictive (for example, income statements, cash flow, external ratings, age, employment history), and can show exposure calculations for risk management and compliance with all data delivery aspects in the Basel II minimum requirements. Further, the availability of an IRB will also be advantageous for BNL managers who make credit decisions and define pricing, as it allows management autonomy in defining credit risk in line with international best practices.

BNL has completed the first part of the IRB project relating to the initial stage of credit risk analysis for client businesses. According to Giovanni Porcelli, Portfolio Monitoring Manager for BNL, "The automatic document generation provided with the SAS solution enabled us to develop a properly documented project: this is an important consideration, especially at the prototype development stage, and it enabled us to enhance the level of cooperation between the different teams."

"Where the statistical models were concerned," continues Porcelli, "there was no need to develop anything in-house, because the solutions provided by SAS were more than adequate. I should also add that SAS software is particularly adaptable; it allowed us to execute several variants of the main model over a few days, while keeping track of all the trials we carried out."

The Forward View
BNL is now working on the development of the next phases of the project, which will be aimed at strengthening their internal ratings capabilities to: report the portfolio's risk profile to bank management and the board of directors; improve credit risk pricing and enhance budgeting criteria; evaluate the quality of portfolios comparing the quality of business between different areas and industry sectors; and perform stress tests to assess capital adequacy.

"So far, we have developed what we call a foundation model of credit risk measurement," explains Porcelli, "but we shall probably need to implement an advanced model, to take into account the credit default time conditions and all the other parameters characterizing the degree of risk of our portfolio." (Note: the IRB is broken down into either a "foundation approach" that allows banks to internally estimate probability of default and an "advanced approach" that gives additional freedom in the internal estimation of credit risk constituents).

Parrillo concludes: "Thanks to the flexibility of the SAS solutions we have used, we have succeeded in fully meeting the Basel II project requirements, and we have laid a solid foundation for the implementation of the subsequent phases." BNL intends to continue a successful relationship with SAS to coordinate and implement their Basel II activities over the next few years.

A Step Up on the Competition
With SAS' help, BNL is well on their way to complying with the risk sensitive framework of the new Basel II accord, which will translate into substantial savings on capital requirements. Exposure to credit risk will be more accurate and transparent, enabling management to make strategic decisions based on improved and timely information. Credit policies and processes will be more effective and efficient, and the quality of data will be improved.

When the Basel II regulations are promulgated, banks MUST comply with them. Therefore, it is not only advantageous, but also critical, for financial institutions to act soon to ensure having a process in place to be compliant in time. Acting now gives a bank a lead over its competition. With this view, BNL is already ahead of the game.

About BNL
BNL is a leading Italian banking group and one of the top 100 banks worldwide. BNL, privatized in 1998, has over 670 branches, 22,300 employees, and 3 million customers in Italy. The BNL Group offers a wide range of banking, finance and insurance services to meet the requirements of its clients in the retail, corporate and public administration sectors.

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