Sound credit risk assessment and valuation for loans

This paper is intended to provide banks and supervisors with guidance on sound credit risk assessment and valuation policies and practices for loans regardless of the accounting framework applied. As such, the principles in this paper are intended to be consistent with those set forth in the International Financial Reporting Standards (IFRS) applicable to loan impairment. Specifically, the paper addresses how common data and processes may be used for credit risk assessment, accounting and capital adequacy purposes and highlights provisioning concepts that are consistent in prudential and accounting frameworks. This guidance focuses on policies and practices that the Basel Committee on Banking Supervision2 believes will promote sound credit risk assessment and controls.

This supervisory guidance is structured around ten principles:

  1. A bank’s board of directors and senior management are responsible for ensuring that the bank has appropriate credit risk assessment processes and effective internal controls
  2. A bank should have a system in place to reliably classify loans on the basis of credit risk.
  3. A bank’s policies should appropriately address validation of any internal credit risk assessment models.
  4. A bank should adopt and document a sound loan loss methodology.
  5. A bank’s aggregate amount of individual and collectively assessed loan loss provisions should be adequate to absorb estimated credit losses in the loan portfolio.
  6. A bank’s use of experienced credit judgement and reasonable estimates are an essential part of the recognition and measurement of loan losses.
  7. A bank’s credit risk assessment process for loans should provide the bank with the necessary tools, procedures and observable data to use for assessing credit risk, accounting for loan impairment and determining regulatory capital requirements.
  8. Banking supervisors should periodically evaluate the effectiveness of a bank’s credit risk policies and practices for assessing loan quality.
  9. Banking supervisors should be satisfied that the methods employed by a bank to calculate loan loss provisions produce a reasonable and prudent measurement of estimated credit losses in the loan portfolio that are recognised in a timely manner.
  10. Banking supervisors should consider credit risk assessment and valuation policies and practices when assessing a bank’s capital adequacy.

Some of these principles have been abbreviated – you shoould refer to the whole document for complete information.

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