Risk Management and Basel II

This chapter introduces the Basel II framework and discusses how probability default (PD) and loss given default (LGD) are addressed and other operational management issues. Basel II is primarily a set of guidelines (framework) for the supervisionof capital. Most banks use an internal rating-based (IRB) approach to determine credit risk based on borrowers’ probability of default. During economic downturn losses on defaults are often greater than normal. Many banks seek to assess loss given default (LGD) on an exposure-by exposure basis (risk on a loan-by-loan basis). Most banks do not as yet assess risks on a portfolio basis. In the banking world, there is a variety of practice with respect to the risk rating process, ranging from systems almost purely driven by statistical models, like credit scoring, to those based almost exclusively upon judgment.