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Update Newsletter: Fall 2002 – Special Conference Issue

Credit Risk Modeling: The Federal Reserve Bank of Philadelphia's Perspective

Summary of Credit Risk Modeling & Decisioning Conference Keynote Address
Anthony M. Santomero, President, Federal Reserve Bank of Philadelphia

Spurred by progress in financial theory and advances in technology, today's financial marketplace is the scene of dramatic change. President Anthony Santomero's keynote address focused on the conference theme of credit risk modeling and the Fed's role in risk regulation.

He began his remarks with an explanation of the Fed's historical interest in the risk imbedded in financial institutions. Over the last few decades, there has been an important shift in the Fed's approach to regulation, moving from a system of portfolio restrictions and crude leverage ratios to a more subtle view of risk-based capital requirements.

The original international agreement on commercial bank capital standards, the Basel Capital Accord, was introduced in 1988. More recently, the Fed and the international regulatory community have been working to update the original agreements with a more sophisticated approach to risk-based capital measurement.

The new proposal includes the use of up-to-date financial models in determining required capital. Santomero noted the proposal "extends both an olive branch and a challenge to the banking industry." Under this proposal, banks could satisfy the new capital requirements under Basel II using their own internal risk-based models, if in the judgment of their regulator they have the capacity to appropriately make these risk estimations. Santomero described this internal risk-based approach as an important evolutionary step toward full portfolio risk modeling and risk-based regulation.

He also emphasized that this approach introduces greater market discipline to the risk regulation framework another critical component of a safer and more stable financial system. "For us at the Fed," he said, "it meant a substantial increase in our commitment to analyzing and understanding the industry's internal risk-based models."

Profit motives have also been driving banks to ramp up their risk modeling efforts, particularly on the commercial side. As he explained, it has made economic sense to devote resources to evaluating the idiosyncratic risk factors of larger loans. However, retail credit risk cannot be ignored. Over the past decade, the industry has devoted significant resources to developing sophisticated credit risk models to measure and better manage these consumer portfolio assets.

The revolution in information and communications technology has led to greater sophistication in the quantitative techniques used in consumer credit risk management and the evolution of credit scoring models. As a result, we have more efficient means than ever before to slot loans into appropriate risk classes. Given this ability, there may be more potential in the retail sector to employ risk-based pricing and target marketing than in most areas of commercial lending.

Nonetheless, Santomero cautioned that the work is not simple, and it is not complete. There is much ground still to be covered. While the sophistication of automated scoring has increased, only recently have many institutions allocated the necessary resources to developing the advanced modeling techniques needed to appropriately assess total portfolio risks and economic capital requirements.

Given the increasing importance and complexity of retail credit exposures, it is vital that regulators gain a greater understanding of current industry practices, as well as areas for improvement. The Federal Reserve Bank of Philadelphia is committed to playing an important role in this process. First, the Philadelphia Fed is the home of the Payment Cards Center, which encourages collaboration among bankers, academics, and policymakers in examining critical issues facing the industry. This conference event, which was co-sponsored by Wharton's Financial Institutions Center, is but one example of how we attempt to provide meaningful insights into industry issues.

More recently, this Reserve Bank has taken on the System responsibility to expand the Fed's knowledge of advanced approaches to quantifying retail credit risk. A working group has been assembled to focus on these issues and participate in a joint effort of the Federal Reserve and other U.S. regulators.

Finally, our Bank's Research Department will sponsor a conference on Retail Credit Risk Management and Measurement in April 2003. A call for papers has been distributed, and selected papers will be published in a special conference edition of the Journal of Banking and Finance.

In closing, Santomero noted that, through these and other initiatives, he sees the Bank's work as the beginning of a necessary and important effort in better understanding this important sector of the financial services industry. He urged conference participants to continue their efforts in the critical area of credit risk modeling. He emphasized, "As experts in our various disciplines, we have the responsibility to formulate new ideas that will further our fields." He continued, "Only by sharing our knowledge and creativity can we develop a new paradigm that will serve our shared purposes."

Read Santomero's speech PDF in its entirety.