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Achieving an adequate balance between the level of complexity, objectivity and comparability which is required within the capital framework

Ojo, Marianne (2014): Achieving an adequate balance between the level of complexity, objectivity and comparability which is required within the capital framework. Published in: International Conference Proceedings of the Planetary Scientific Research Committee (May 2015)

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Credit ratings have assumed an increasingly formidable and important role over the years. An increased role and revisions to its foundations, have been triggered, not only in view of the shortcomings of credit ratings based criteria, as revealed through the recent Financial Crisis, but also the need to update Basel II - which has served as the foundation for credit ratings in several jurisdictions. Credit ratings serve various vital purposes, most notably of which include the determination of capital requirements, the identification and classification of assets, and the provision of reliable estimation and assessment of credit risk.

The criteria required to be satisfied by credit rating agencies, namely: objectivity, independence, transparency, disclosure, resources and credibility, are closely linked, since the level of comparability and consistency of information provided by such agencies, could also serve as a useful indicator that such information is reliable and credible.

In response to the changing financial environment - the evolution and emergence of new and more complex forms of risks and financial products, credit rating agencies have extended their scope beyond the coverage of their traditional products. As well as assessing whether the scope of products presently covered by rating agencies could be deemed adequately relevant to the criteria required to satisfy information being provided as credible, this paper also addresses the reliability of credit scoring methods and models. Are those measures used in estimating the probability of default, namely, financial statements, market prices of a firm’s debt and equity, and appraisals of the firm’s prospects and risk sufficiently indicative as to provide a reliable estimate of the firm's probability of default?

The vital role of audits in verifying the credibility of information in financial statements is therefore evident. The reliability and consistency of credit ratings across different jurisdictions, sectors - financial, non financial sectors, and rating agencies, as well as the reliability of the approach for assessing ratings constitute major areas to be addressed. This in part, being attributed to the difficulties with achieving a balance between risk-sensitivity and comparability.

The Basel III leverage ratios also being crucial to achieving an acceptable balance with risk-sensitivity - such that the capital framework is not considered unduly risk-sensitive - as was the case with Basel II.

The increased importance attributed to credit ratings is also reflected by the Basel Committee’s recent introduction of the Standardized Approach (SA-CCR) for measuring exposure at default (EAD) for counter-party credit risk (CCR). The SA-CCR is intended to replace both current non-internal models approaches, the Current Exposure Method (CEM) and the Standardised Method (SM). The SA-CCR will apply to OTC derivatives, exchange-traded derivatives and long settlement transactions. Risk models have certainly become increasingly complex and relevant - however, is such level of complexity correspondingly and adequately balanced with the level of objectivity and comparability which is required within the capital framework?

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