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**The Basel II "use test" requires significant resources to implement, but it promises to usher in an exciting new era for banking.
TUCKED AWAY AMID the 800-odd paragraphs of the Basel Committee on Banking Supervision's International Convergence of Capital Measurement and Capital Standards: A Revised Framework, otherwise known as the Basel II Framework, are two paragraphs relating to a "use test" directive.
Under the "Use of Internal Ratings" heading, paragraphs 444-45 describe the degree to which financial institutions must incorporate Pillar 1 model estimates and the composite elements of expected loss, risk-weighted assets, and regulatory capital into everyday banking practices for three years prior to obtaining regulatory approval. A memo issued by the Basel Committee in September 2006 enhances the use test by broadening its operational, governance, and fiduciary impacts. This treatise lays down principles giving retail credit bankers freedom to execute strategies in line with their market approach and to maximize bottom lines by optimizing the risk-reward relationship.
Traditionally, retail-credit-granting institutions have given less attention to integrating sophisticated decision-making tools into everyday banking processes throughout the credit cycle. Retail banks successfully implementing the use test have demonstrated core competencies for models and governance throughout the origination, management, and disposal of retail credit assets. These competencies include validation and stress testing, capital adequacy reporting, expected and unexpected loss measures, and audit and disclosure controls. Pillar 1, 2, and 3 rigors within credit, market, and operational risk must be integrated into bank credit practices. In addition, the endorsement of senior management, executives, the board, and regulators must be obtained. Basel II elicits banks to tie provisions and capital to their own risk tolerance. Retail banks also must achieve project investment return while employing Basel II model estimates.
Minimum Requirements for Use Tests
Incorporating the use-test precepts is daunting while maintaining established capital hurdle rates, portfolio credit quality standards, overall profitability, and development of new products and services leading to shareholder content and corporate profitability. Banks aspiring to Basel II advanced internal-ratings based (AIRB) compliance must reach these milestones. The challenge lies in balancing the opinions of senior management, executives, the board, audit, and the regulatory bodies in a cohesive, sustainable fashion. The use test identifies elemental requirements that enable banks to make the leap...