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Basle II: Random Walk No More
November 3, 2003

The scenario is now familiar. A company with apparently strong financials stumbles. The healthy balance sheet is shown to be a fiction. Then, the worst-case scenario unfolds: executive suite fraud is revealed, the company restates its numbers, equity prices tumble and creditors begin to deal with the losses. Long-term liabilities accelerate and the business eventually defaults via bankruptcy.

Such sudden implosions are unpredictable and rare. In the past 20 years, catastrophic defaults stemming from management misconduct in large cap companies have occurred so infrequently that risk modeling systems ignore such events. But no longer. The events leading to the SEC�s new Sarbanes-Oxley regulations demonstrate the consequences of allowing sensitivity to management fraud to degrade.

The Basel II banking accord scheduled for worldwide implementation in 2007 spotlights the deficiencies in credit risk modeling. For banks adopting the advanced Internal Research Based (IRB) risk modeling protocol, the explicit computation of probability of default (PD), exposure at default, maturity and loss given default will not only need to be computed inhouse but are reportable on demand to regulators. The bottom line: risk modeling has to change to include fundamental analysis and thereby become sensitive to firm-specific risks.

Today there are three families of risk analysis widely used by risk managers. For companies with stable financial profiles, quantitative factoring systems such as the Altman Z-Score technique are useful. For companies with limited histories or known exposures to discrete event risks, cash-flow simulation systems similar to macroeconomic shock modeling are available.

In the early 1990�s a third technique evolved for publicly traded names based on the efficient market hypothesis. Using the theory that equity market prices were the sum of all market information and thus equivalent to an accurate credit opinion, Merton models rapidly gained acceptance. But you cannot model fraud.

Connecting equity valuations with financial health provides an incentive for blue chip companies to window dress. Earnings mad CFOs stretch GAAP to the limit to please Sell- Side analysts. As the economic cycle turns down, pressure to �dress for success� on large cap, big trading volume firms becomes even greater. Remember: equity market valuation = your PD.

There is no way to remove aggressive corporate behavior from the business equation. The success of free market enterprise relies on it. But it is possible to apply standardized fundamental screening to measure specific corporate behavior and factor deviations from the norm into credit risk modeling. These forensic screens can generate �red flags� that indicate the need to switch from traditional modeling approaches to more risk sensitive versions that include proactive diligence and fundamental analysis.

Under Basle II, regulators expect financial institutions to be able to perform detailed credit analysis on counterparties as part of the cost of admittance to the party. If you want the more flexible capital allocation rules of Basle II, you must have two buckets: In the first are the familiar, top-down risk modeling tools the industry employs today; and second, an internal capability to perform detailed fundamental PD analysis on specific names. Customers are going to be compelled to provide lenders and agents with more detailed types of financial information more frequently, and the risk professionals will be held to a far higher level of accountability in terms of the counterparty PD analysis that they perform � or fail to perform.

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