Optimizing credit strategies to manage impact

Whilst there was general agreement on the need to reform the global financial system after the 2007 financial crisis, the impact of the revised regulations published in 2009 by the Basel Committee on Banking Supervision has been felt far and wide. The challenge facing many financial services organizations is how they respond in a timely way to regulation changes while meeting obligations to maintain and grow shareholder value and profitability.

Although not seriously impacted by the financial crisis, Asian banks have learnt from it and have felt pressure to implement tighter regulatory measures, like Basel III, to prevent such an event happening again, in Asia or globally. Basel III, which will be implemented from January 1, 2013 in China and Hong Kong, puts focus on the right type and availability of capital.

The key elements of Basel III are designed to improve banks' liquidity management and increasing the size and quality of the regulatory capital they hold. Basel III tightens the previous requirements, forcing banks to raise their core tier one capital ratios from 2 percent to 7 percent to ensure they will not need government assistance should they run into financial distress in the future. Industry analysts predict that China's five largest banks will have the least difficulty complying to this as they are all well capitalized, whilst midsize and smaller Chinese banks will face increased pressure owing to their weaker capitalization. To ensure capital adequacy, each bank should assess their current risk levels, and run stress tests to ensure they are in a good financial position, and able to sustain strong financial health during a failing economy.

Banks are reacting swiftly to these new regulations to offset the negative impact on their return on equity and profitability. Some important top-down initiatives, known as 'risk-weighted assets optimization strategies', include: strategic and organizational changes; asset liability management initiatives; changes in the structure of their portfolio composition; and optimization of credit and sales strategies to reduce capital charges

A bottom-up operational approach can also be very effective. Banks will have to focus on maximizing their risk-adjusted performance to make the best lending decisions, given their business and regulatory constraints. As China's rapidly growing real estate, energy, automotive, pharmaceuticals and manufacturing industries rely heavily on loans from banks, banks will need to be more cautious when lending in order to comply with the higher capital ratio and manage the challenge of liquidity shortfall.

A well-designed decision optimization framework would help provide a roadmap to develop a credit strategy that is best aligned with business goals.

The first step is focused on analyzing data to identify client, risk, income and financial variables, as well as propensities and sensitivities. Next, banks need to define goals, such as risk-adjusted profitability, and estimate correlations between different variables. After that, an organization can apply it to specific portfolios, building and analyzing different scenarios and setting different constraints using dedicated simulation software tools. Finally, powered by a decision engine, the optimized credit strategies, designed in the simulation and testing environment can be deployed to the bank's decisioning process.

Business analytical models and tools can help organizations not only address compliance issues, but also transform those regulatory requirements into compelling competitive advantage. The optimization framework is a powerful tool that can improve the efficiency and profitability of organizations not only in the area of credit strategies and decisions, but also across several other areas of their business like marketing and collections.

The author is managing director of Decision Analytics at Experian Asia Pacific. The views expressed here are entirely his own.