Value at Risk and Bank Capital Management

for loan commitments, since a distressed borrower is likely to use a substantial part of

initially undrawn loan commitments before defaulting, unless the bank has the chance to

revoke the commitment and is able to anticipate the problem. The problem is more relevant

for high-quality borrowers, since they can obtain larger commitments and the difference

between the drawn portion in normal conditions and at default may be larger (see Table

4-9).

As a consequence, Basel II forces banks adopting either the standardized or the FIRB

approach to translate off-balance sheet items, such as loan commitments, into credit-

exposure equivalents by multiplying them by a credit-conversion factor (see Basel Com-

mittee 2006a, §§82–87 and §§311–315). Only facilities that are unconditionally cancellable

by the bank or are automatically cancelled in case of a deterioration in borrower’s credit-

worthiness are given a 0% credit-conversion factor. In the AIRB, banks may estimate

EAD internally but, again, adopting a conservative approach, especially for exposures

where EAD were expected to increase during downturns (Basel Committee 2006a, §475).

In fact, both PD and EAD are likely to grow in bad years, and this could make unexpected

losses higher than if they were independent. Therefore, even banks that will not apply for

the AIRB approach should try to study the potential correlation between the use of the

undrawn portion of loan commitments, default rates, and the economic cycle, since this

information should enter into the pricing policies for commitments and provide further

incentives to continuous credit monitoring. In fact, even in those cases where a credit line

can be discretionally revoked and hence would not imply any extra exposure and a specifi c

capital requirement, the undrawn portion of the credit line represents a risk for the bank,

unless the bank’s credit-monitoring system (based on either a behavioral score or periodic

credit review by analysts) proves to be able to anticipate the deterioration of the borrower’s

fi nancial health.

4.8 Interaction between Basel II and International

Accounting Standards

So far we have discussed credit risk management issues from the viewpoint of risk man-

agers and supervisors. But a third perspective has to be considered: accountants’ view

about credit risk. This topic is particularly relevant now for European banks due to the

introduction of new IAS/IFRS accounting principles and the consequent potential con-

cerns for their consistency with supervisors’ and risk managers’ objectives. We should

TA B L E 4 - 9 Drawn and Undrawn Portions of Loan Commitments as a Function of Initial

Rating

Rating Class Drawn Portion of Loan Commitment Average of the Normally Undrawn Portion

That Is Drawn in Case of Default

AAA 0.1% 69%

AA 1.6% 73%

A 4.6% 71%

BBB 20.0% 65%

BB 46.8% 52%

B 63.7% 48%

CCC 75.0% 44%

Source: Asarnow and Marker (1995).

INTERACTION BETWEEN BASEL II AND IAS 93