Impacts of the foundation internal ratings based approach usage on financial performance of commercial bank

Abstract

The aim of this article is to present theoretical, methodological and practical aspects of internal rating model's validation for commercial banks and quantify potential impact of foundation internal ratings based approach on financial performance of banks. The quality and the explanatory ability of internal rating systems can be different. Models used to measure credit risk are not perfect and give quite unreliable results, respectively; they contribute to the procyclical tendencies of the financial system. This article was based on the assumption that a suitably chosen rating system can significantly support long-term profitability and competitiveness of commercial banks. One part of the article also presents methodology of additional profitability on equity of the bank due to the usage of internal rating models. The analyses has proved that the usage of internal rating models increase profitability through substantial savings in equity, which allows the banks to accelerate lending activities in the banking practice. A comparison of standardized approach and foundation internal rating based approach demonstrates that requirement of equity capital can be decreased from 30 to 40 %. Under the condition of the anticipated savings in equity of 30 %, the usage of internal rating model could increase the profitability on equity up to 13 %, depending on the structure of assets, amount of the interest margins and profitability ratio. Future usage of internal rating based approach is quite uncertain since it has shown its procyclical character and has significantly contributed to the acceleration of the global financial crisis by lower capital requirement. However, internal rating based approach implementation is very intensive in the credit risk management of the bank, therefore there is rather suggested a gentle modification in this area and not a complete elimination. It has been considered a neccessity to reassess its status in area of solvency, because of its intensive impact on reduction of equity capital.