Fitch on Basel II: Navigating Through The Internal Ratings-Based Approach.

NEW YORK & LONDON -- The Basel II capital framework, which was finalized in June, is a major step in regulation that will promote stronger risk management and disclosure practices within the banking industry, according to Fitch Ratings. Indeed, one of the important innovations in Basel II is the internal-ratings based (IRB) approach to measuring regulatory capital for credit risk, which harnesses advanced risk measurement techniques.

A new report by Fitch decodes the technical underpinnings of the IRB approach and provides guidance for investors and analysts to understand the new Basel II credit risk measures. Fitch believes that these measures will be a helpful tool in evaluating a bank's capital adequacy, particularly when combined with an analysis of other important risk drivers, such as portfolio concentration.

'IRB banks must have the infrastructure and capabilities to assess their credit risk exposure in a systematic and rigorous way,' said Kim Olson, Managing Director, Credit Policy, Fitch Ratings. 'As such, Fitch generally will view adoption of the advanced IRB approach positively in our credit analysis of larger, more sophisticated global banks.'

Fitch welcomes the greater risk-sensitivity of the Basel II framework and believes it will provide a better yardstick of a bank's capital relative to its risk profile. A by-product of greater risk-sensitivity is that the IRB measures could fluctuate significantly over time, improving in a robust economy but declining during a downturn.

'It is incumbent on banks, particularly when credit markets are strong, to take a forward-looking view of the capital needed to weather the range of risks that can occur over the course of the economic cycle. Fitch therefore views risk assessment techniques such as stress testing as important elements of a bank's capital strategy,' said Charles Prescott, Group Managing Director, Financial Institutions, Fitch Ratings.

A point of strong interest within the industry is how much capital banks will have to hold under Basel II for different asset categories. Fitch provides a way of looking at this by comparing the IRB capital charges on commercial real estate and residential mortgage loans with the enhancement levels for different target ratings on structured products composed of these assets.

'While there are a number of important methodological differences to bear in mind, the comparison between the IRB charges and Fitch's enhancement levels provides a new perspective on the relative amount of capital needed to cover credit risk under Basel II,' said Martin Hansen, Director, Credit Policy, Fitch Ratings.

An important tool in helping to understand a bank's IRB capital ratios is the enhanced disclosure required under Pillar 3 of the new Basel framework. Fitch believes that it will be important for market participants to review these disclosures carefully and to devise ways to make meaningful comparisons of risk across banks.

'The Basel II disclosures provide greater transparency and new opportunities for a broad range of market participants to better understand a bank's risk profile,' said Olson. 'At the same time, the challenge will be to understand what's driving the numbers and to view them more broadly within the context of the bank's capital allocation strategy, ratings philosophy, and economic capital systems.'

The report 'Demystifying Basel II: A Closer Look at the IRB Measures and Disclosure Framework' is available on the Fitch Ratings web site at 'www.fitchratings.com'. The web site requires users to perform a simple log on process. The report can be found by linking to 'Banks' (under 'Financial Institutions') and then clicking on 'Special Reports'.